CHARTERED INSTITUTE OF STOCKBROKERS
ANSWERS
Examination Paper 2.2
Corporate Finance
Equity Valuation and Analysis
Fixed Income Valuation and Analysis
Professional Examination
March 2014
Level 2
SECTION A: SOLUTION MULTI CHOICE QUESTIONS
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
C
C
A
C
D
C
C
B
C
D
A
D
A
B
B
C
B
D
A
B
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
A
A
C
B
B
D
D
B
A
C
D
C
C
D
A
C
D
C
A
C
(40 marks)
SECTION B: SOLUTION TO SHORT ANSWER QUESTIONS
Solution to Question 2 – Corporate Finance
Potential Benefits to IBTT Limited shareholders:
i.
The Shareholders of IBTT Limited will have their portfolio risk diversifies as their
firm will now be bigger most likely with stronger management team.
ii.
The value of the firm's shares may be increased in case of poorer valuation as the
acquiring firm offers a premium for the value of the shares of IBTT Limited to
encourage its shareholders to accept the offer.
iii.
They can benefit from reduced costs, synergies and hence the profitability of their
companies.
iv.
The creation of synergies that result from a takeover is important as it is one way
a firm can gain long-term profitability and will affect the shareholders positively.
v.
The new firm may benefit from economies of scale and share knowledge and
increase the shareholders’ confidence.
vi.
The return on investment may be better after the takeover.
Drawbacks to shareholders
i.
Loss of Control of Board & Management by erstwhile shareholders of IBTT
ii.
In some cases, IBTT may suffer from lower valuations because of weaker
bargaining power, in that instance, shareholders lose.
iii.
The shareholders' shares may be reduced by volume due to capital reconstruction
mechanism applied by the acquirer.
iv.
The objectives of the acquirer may not be in conformity with the shareholders'
believe or aspiration.
v.
The type of dividend policy to be adopted may affect the shareholders.
(3 marks)
Solution to Question 3– Equity Valuation and Analysis
Economic value added (EVA) is an internal management performance measure that
compares net operating profit to the total cost of capital.
The formula for EVA is:
EVA = Net Operating Profit After Tax - (Capital Invested x WACC)
EVA implies that businesses are only truly profitable when they create wealth for their
shareholders, and the measure of this goes beyond calculating net income. Economic
value added asserts that businesses should create returns at a rate above their cost of
capital.
Example:
A Company has the following components to use in the EVA formula:
Net operating profit after tax, NOPAT = N2,500,000
Capital Investment = N30,000,000
WACC = 10%
EVA = N2,500,000 - (N30,000,000 x 0.10) = -N500,000
A negative number as above, indicates that the project did not make enough profit to
cover the cost of doing business.
(3 marks)
Solution to Question 4 – Fixed Income Valuation and Analysis
The price of the bonds of Connect Telecoms Ltd will fall when downgraded from A to
BBB.
On the other hand, the yield to maturity (YTM) will increase upon the downgrade.
The reason is that a downgrade implies higher risk; and the higher the risk, the higher
the yield needed to compensate the investor.
When the market perceive the yield on a bond to be too low, it's price will fall to bring
the yield in line with market expectations or prevailing interest rate.
(4 marks)
SECTION C: SOLUTION TO ESSAY TYPE, CALCULATION AND/OR CASE STUDY QUESTIONS
Solution to Question 5 – Corporate Finance
Solution 5(a)
We are given,
Tc=42%, D/E=35%, Rf = 2.5%, Risk premium = 5%, Kd = 5%, βa = 1.3
βe = βa { 1 + (1 - t) D/E}
= 1.3 { 1 + (1 - 0.42) 0.35}
= 1.5639
= 1.56%
(2 marks)
Ke = Rf + (Rm - Rf) β
=2.5% + 5% * 1.56
= 2.5% + 7.8%
= 10.3%
(1 mark)
Weighted average Cost of Capital, WACC:
WACC =
D
* Kd (1 - t) + E
* Ke
D+E
D+E
since D/E = 35% = 35
100
Therefore,
D
D+E
=
WAACC =
35
35 + 100
35
135
* 5% (1 - 0.42) + 100 * 10.3
135
= 0.75% + 7.63%
WACC = 8.38%
(2 marks)
(5 marks)
Solution 5(b1)
FCFE
2014
2015
2016
2017
2018
(1,342)
(1,107)
(730)
(140)
396
(1 mark)
Discount Rate (9%) 0.9174
0.8417
0.7722
0.7084
0.6499
Present Value (PV)
(932)
(564)
(99)
257
(1,231)
(1 mark)
Net present value = (N2,569)
(2 marks)
Solution 5(b2)
The last year cash flow was in 2018. We have assumed 2018 as the terminal year for
this question.
The Terminal Value is therefore Cash flow in 2018*(1+g)/(k-g)
Terminal Value (2018) = 396(1+0.05)/(0.09-0.05)
= N10,395
Present value of the Residual value,
= 396 (1 + 0.05) * 0.6499
WACC - g
= 396 (1 + 0.05) * 0.6499
0.09 - 0.05
= 415.8 * 0.6499
0.04
= 10,395 * 0.6499
= N6,756 million
(2 marks)
Solution 5(b3)
Theoretical Share Price for Tissan is
= -2,569 + 6,756
= N4,187 million
Number of ordinary shares = 15 million
Theoretical Share price =N4,187million
15 million
= N279 per share
(3 marks)
Solution 5c
Alternative fund raising options are:
i.
ii.
iii.
iv.
v.
vi.
vii.
i.
ii.
iii.
iv.
v.
Convertible bonds
the most appropriate
Preference shares
Corporate Bonds
Bank Overdraft & Loans
Unsecured Credits from its suppliers
Assets Sales
Assets Financing & Factoring
The Rational for bonds is that it is tax deductible but carries solvency risk.
Bank Overdraft is also easier to access for reputable companies but also carries
solvency risks and excessive costs of borrowing
Assets Sales is selling some fixed assets of the company to raise cash that may
not really affect their core operations. It can send a distress signal to its publics.
Exploring Suppliers Credits can help companies converse cash but the company
can lose goodwill of its customers.
Factoring is selling the company's debt to third party for immediate cash. This
supposes that there are debts to sell. The buyer of such debt may apply recovery
strategies that may hurt the company's business in the long run.
(4 marks)
Solution to Question 6 –Equity Valuation and Analysis
Solution 6(a)
Using the Gordon Growth Model would be inappropriate to value MFL’s equity for the
following reasons:
i.
The Gordon growth model assumes a set of relationship about the growth
rate in dividends, earnings, and stock values. Specifically, it assumes that
dividends, earnings, and stock values will grow at the same constant rate.
In the case of MFL, the Gordon growth model is not appropriate because
management’s dividends/policy has held dividends constant in Naira value
although earning have grown, does reducing the payout ratio. This policy
is inconsistent with the Gordon growth model assumption of a constant
payout ratio.
ii.
It could also be argued that using the Gordon growth model given MFL’s
dividend policy violates one of the general conditions for suitability of use,
namely that a company’s dividend policy bears an understandable and
consistent relationship to the company’s profitability.
iii.
The investment company (i.e. the prospective investor) is taking a control
perspective (60% in this case). The investor may change the company
dividend policy substantially, for example it may set a level approximating
MFL’s capacity to pay dividend. The Gordon growth model assumes noncontrol perspective.
iv.
To apply the Gordon growth model, you must first know the annual
dividend payment and then estimate its future growth rate. But estimating
your required rate of return for the stock, also known as the "hurdle rate"
or "cost of capital" is a bit more challenging and requires a few more items
of information. It may not be appropriate for an estimate of dividend
growth and cost of capital because an important ingredient in the formula
is lacking.
(2 marks)
Solution 6(b)
The use of r and BVDo is not appropriate because the single-stage free cash flow to the
firm valuation model is given by:
Firm value = FCFF0 (1 + g) / (WACC - g) = FCFF1/(WACC - g)
This model is employed when free cash flow to the firm is expected to grow at a stable
rate indefinitely extending in the future.
The model makes use of WACC that takes into account cost of debt and not cost of
equity only which is given by (r) and does not subtract Book Value of Debt. Book Value
of Debt is not removed from the firms total value.
The formula subtracts BVDo which is inappropriate.
R – Inappropriate. Since the company is geared, weighted average cost of capital
should be used to discount FCFF.
BVDo - Inappropriate. The market value of debt should be used.
(2 marks)
Solution 6(c)
The variables that Yaro should use is given here:
FCFFo (1 + g) / (WACC - g)
(1 mark)
Solution 6(d)
Computation of Free Cash flow to Equity (FCFE)
NWC = Inventory + accounts receivable – accounts payable
2013 : 15,476+9,750-2,040
2012 : 13,940+11,645-4,250
Increase in working capital
₦’000
23,186
21,335
1,851
=
=
Purchase of non-current assets
Closing net book value
Add: depreciation for the year
Less: opening net book value
Non-current asset purchased
₦’000
32,500
8,425
-20,231
20,694
Loan repayment
Opening short-term loan
Opening non-current loan
₦’000
2,000
9,745
Closing short-term loan
Closing non-current loan
Loan repayment
1,500
4,511
₦’000
11,745
6,011
5,734
FCFE = PAT + Depr - WC + Debt
= 41,650 + 8,425 – 20,694 – 1,851 +(-5,734)
= 21,796(₦’000)
= ₦21,796,000
(4 marks)
Solution 6(e1)
(i) First, we need to determine the equity beta using :
βE = βA + (βA – βD) D/E (1-t)
0.2
D
/E =
0.2
=
(1 - 0.2)
= 0.25
0.8
(Note that Debt/Asset i.e. D/E+D is given)
βE = 0.64 + (0.64-0)(0.25)(1-0.3) = 0.752
Using CAPM:
Cost of equity is:
4% + (0.752 x 8%) = 10%
(3 marks)
Solution 6(e2)
First, we determine the terminal value at the end of year 4 (TV4)
20(1.15)4(1.025)
FCFE5
TV4 =
=
r-g
= ₦478.06 million
0.10 – 0.0
Next, we compute Vo, the total current market value of equity:
₦'m
FCFE1
20(1.15)1
Yr1 =
=
= 20.91
(1+r)1
1.10
20(1.15)2
FCFE2
Yr2
=
(1+r)2
=
20(1.15)3
FCFE3
Yr3
=
Yr4
=
(1+r)3
= 21.86
(1.10)2
=
= 22.85
(1.10)3
FCFE1 + TV4
(1+r)4
20(1.15)4 + 478.06
=
= 350.41
(1.10)4
(1.10)4
Total Value
=
Vo
= ₦416.03m
(4 marks)
Alternatively:
The above approach is not necessarily prescriptive, candidates can use several
methods leading to the same acceptable result. For example, the following
alternative method can be used:
First 4 years, when g = 15%
We can use growing annuity:
PV
=
FCFE0 (1+g) 1r–g
1+g
1+r
4
PV
20 (1.15)
=
0.10-0.15
1-
1.15
4
1.10
= 89.51
Years 5 to infinity, when g = 2.5%
FCFE5 (1 + r)-4
r-g
PV =
20(1.15)4 (1.025)
PV =
x (1.10)-4
= 326.52
0.10 – 0.025
Total PV = Vo = 89.51 + 326.52
= ₦416.03 million
Solution to Question 7 – Fixed Income Valuation and Analysis
Solution 7(a)
The objective of immunisation centres around mitigating the two components of interest
rate risk – price risk and coupon reinvestment risk. Keeping this in mind, many feel that
zero coupon bond is the ideal financial instrument to use for immunisation because it
eliminates these risks, and thus eliminates the need to rebalance the portfolio.
Reinvestment risk is eliminated because there are no intervening cash flows to reinvest,
and price risk is eliminated because if you set the duration equal to your time horizon,
you will receive the face value of your bond at maturity.
(3 marks)
Solution 7(b)
PV of Assets
The cash flows expected from the zero – coupon bonds are
Yr
CF (₦)
2
3,000,000
4
3,000,000
6
3,000,000
8
3,000,000
10
3,000,000
A very fast way of doing the discounting is to use annuity. This however demand the
use of 2 – yearly discount rate:
2 – yearly rate:
(1.10)2 – 1
=
21%
The annuity formula is then used:
1- 1.21)-5*
3,000,000
= ₦8,777,953
0.21
(* 5 period of two years each)
Alternative Method 1
3,000,000
PV =
3,000,000
+
(1.10)2
3,000,000
+
(1.10)4
3,000,000
+
(1.10)6
3,000,000
+
(1.10)8
(1.10)10
= ₦8,777,953
PV of Liability
This is given by:
23,078,999(1.10)-10
= ₦8,897,953
23,078,999(1.21)-5
= ₦8,897,953
OR
Surplus
Net Surplus = PVA – PVL
= 8,777,953 – 8,977,953
= ₦200,000.
(5 marks)
Solution 7(c)
A number of methods can be used to compute the duration of the asset, a faster method
is to use the formula for level annuity treating the cash flows as annuity over five
periods (of 2 years each)
1 +Y
D=
n
-
Y
(1+Y)n-1
Where Y = 2 – yearly yield
= 21%
1.21
5
D=
-
= 2.6246 on 2 – yearly basis
(1.21)5-1
0.21
= 5.25 years (2.6246 x 2)
Modified duration of assets (MDA)
= 5.25/1.10 = 4.773
Duration of liability = maturity = 10 years
Modified duration of liabilities (MDL) = 10/1.10 = 9.091
(3 marks)
Alternative solution:
Duration of the asset
Year
Cash flow
₦
Discounting
Factor (%)
PV
₦
PVT
₦
2
3,000
0.826
2,478
4,956
4
3,000
0.683
2,049
8,196
6
3,000
0.564
1,692
10,152
8
3,000
0.467
1,401
11,208
10
3,000
0.386
1,158
11,580
8,778
46,092
Duration =
46,092
8,778
= 5.25 years
Modified duration:
D
1+y
=
5.25
=
1 + 0.1
= 4.773
5.25
1.1
Year
Cash flow
₦
Discounting
Factor (%)
10
23,078,999
0.386
PV
₦
PVT
₦
8,897,953
8,897,953
Duration = 10 years
Solution 7(d)
Let S = Change in surplus
A = Change in assets
L = Change in liability
S = A - L
= -(MDA.PVA - MDL.PVL) Y
= -(4.773 x 8,777,953 – 8,977,953 x 9.091) (-0.0075)
= -(-39,721,401.05) (0.0075)
= -₦297,910.51
The total loss due to the shift in the term structure of the interest rate is
₦297,910.51. Thus, from the above we can conclude that if we have a negative
surplus, for any downward shift in the term structure of the interest rate, we tend
to gain on the asset side and loose on the liability side which results in the net
change to be negative.
(3 marks)
Solution 7(e)
In
order to have a surplus of ₦198,600,
(₦200,000+₦198,000). We know that:
the
S
must
be
₦398,000
S = -(MDA x PVA – MDL x PVL) (Y)
398,000 = -(4.773 x 8,777,953 – 9.091 x 8,977,953) (Y)
398,000 = (39,721,401.05) (Y)
Y
= 0.010 or 1%
Thus, there must be an upward shift in yield of approximately 1% to produce
surplus of ₦198,000.
(4 marks)