CIS March 2013 Exam Diet
Examination Paper 2.2:
Corporate Finance
Equity Valuation and Analysis
Fixed Income Valuation and Analysis
Level 2
Corporate Finance (1 – 13)
1.
AB Ltd recently evaluated an investment project that had an initial cash outlay followed
by positive annual net cash flows over its life. The company employed the internal rate
of return (IRR) and discounted payback period (DPP) methods for the investment
appraisal. Later, it was discovered that the cost of capital figure used was incorrect and
that the correct figure was higher.
What will be the effect on the IRR and DPP of correcting for this error?
Effect on
IRR
DPP
A. No change
No change
B. Increase
Increase
C. Decrease
Decrease
D. No change
Increase
2.
Consider the following two statements concerning convertible loan notes:
I.
A business will aim to issue convertible loan notes with the lowest possible
conversion premium.
II. Convertible loan notes normally have a higher coupon rate of interest than nonconvertible loan notes.
Which of the following combinations (true/false) concerning the above statements is
correct?
Statement I
Statement II
A. True
True
B. True
False
C. False
True
D. False
False
3.
The current annual risk-free rate of return is 6% and the required annual rate of return
on a security with a beta of 1.2 is 15.6%. Using the capital asset pricing model, what is
the required annual rate of return on the market portfolio?
A. 11.52%
B. 13.00%
C. 14.00%
D. 17.52%
4.
An analysis of the financial statements of KK Plc revealed the following:
I.
II.
III.
IV.
A
A
A
A
higher than average inventory holding period.
lower than average acid-test ratio.
higher than average payment period for trade payables.
lower than average sales to fixed assets ratio.
Which of the above statements are consistent with overtrading?
A. I and II only.
B. I and IV only.
C. II and III only.
D. III and IV only.
5.
The Modigliani and Miller (no taxes) proposition concerning capital gearing states that,
as the level of capital gearing increases from zero:
I.
II.
III.
IV.
The
The
The
The
cost of equity capital will increase.
cost of debt capital will remain unchanged.
value of the business will decrease.
weighted average cost of capital will increase.
Which of the above statements are correct?
A. I and II only.
B. I and III only.
C. II and IV only.
D. III and IV only.
6.
Gobi Co has irredeemable 4% loan notes on issue with a nominal value of N20m. The
current market value of the loan notes is N10 million and the tax rate is 25%. The
equity shares of Gobi Co have a total market capitalization of N30million. The
company’s weighted average cost of capital is 10%.
What is the cost of equity for Gobi Co?
A. 10.7%
B. 11.3%
C. 12.3%
D. 12.5%
7.
How should a successful acquisition be evaluated in the long-run?
A. The acquisition is successful if the acquirer is able to increase its earnings per share
(EPS), relative to what it would have been without the acquisition.
B. The acquisition is successful if the acquirer is able to reduce its debt-to-total asset
ratio, and hence risk, relative to what it would have been without the acquisition.
C. The acquisition is successful if the acquirer is able to diversify its asset base and
reduce its overall risk.
D. The acquisition is successful if the market price of the acquirer's stock increases
over what it would have been without the acquisition.
8.
Consider the following two statements concerning finance leasing:
I. The lessor is responsible for the maintenance and servicing of the asset.
II. The period of the lease will cover all, or substantially all, of the useful economic life
of the leased assets.
Which one of the following combinations (true/false) concerning the above statements
is correct?
Statement I
Statement II
A. True
True
B. True
False
C. False
True
D. False
False
9.
The following statements have been made about the probable long-term effects of
introducing a just in-time system of inventory management:
I. Inventory holding costs increase.
II. Labour productivity improves.
III. Manufacturing lead times decrease.
What of the above statements is true?
A. All of the above.
B. I and II only.
C. I and III only.
D. II and III only.
10. Which of the following statements regarding dividend policy is incorrect?
A. A policy of regular cash payouts can help to reduce agency problems.
B. Financial markets with lower transaction costs would generally be expected to have
higher dividend payouts.
C. Financial markets without double taxation on dividends would be expected to have
higher dividend payouts.
D. Companies operating in high growth rate sectors would generally be expected to
have higher dividend payouts.
11. Which of the following statements is (are) true with respect to business risk?
I.
As the variable cost structure of a company increases, so will its degree of business
risk.
II. Business risk will increase the volatility of earnings relative to the volatility of sales.
III. As the debt structure of a company increases, so will its business risk.
IV. During booming economic times, it is more logical to invest in companies with lower
degree of business risk.
A.
B.
C.
D.
II only.
I, II, and III only.
I and III only.
I, II, and IV only.
12. Grob Company management has approved an expenditure of N10,000 to evaluate the
merits of a project that would require the purchase of a machine costing N300,000 and
an additional N50,000 to modify and install it at the firm’s plant. The machine would be
housed in a building that is owned by Grob, but is currently being leased by another
firm for storage.
The present value of the lease is N60,000, and it can be terminated on short notice at
Grob’s option. When analyzing the project for capital budgeting, the initial investment
outlay for this project is closet to:
A. N350,000
B. N410,000
C. N420,000
D. None of the above.
13. A takeover defensive strategy whereby the target company makes a counter bid for the
stock of the bidder is described as:
A. Poisson pills.
B. Greenmailing.
C. Pacman defence.
D. Macaroni strategy.
Equity Valuation and Analysis (14 – 26)
14. An analyst has gathered the following data about a company:
•
•
•
The company has NOPAT of N2 million.
Its capital consists of N10 million in equity with a required return of 12% and N10
million in debt at an interest rate of 8%
The company’s tax rate is 40%
Economic Value Added (EVA) is equal to:
A. N320,000
B. N530,000
C. N680,000
D. N1,120,000
15. When using MVA to assess management’s performance, you should look at:
A. The absolute value of MVA.
B. The change from year to year in MVA.
C. A moving average of MVA over time.
D. The difference between MVA and EVA.
16. The sustainable growth equation relies upon all of the following assumptions except:
A. The firm wants to maintain its capital structure.
B. The firm expects to issue new equity on a regular basis.
C. The firm wants to grow as fast as possible.
D. The firm wants to maintain its dividend policy.
17. Regarding the dividend discount model (DDM), which of the following is false?
A. The required return must be greater than the dividend growth rate.
B. The calculated stock price is sensitive to the dividend growth rate.
C. It can be used for high growth firms.
D. It cannot be used for non-dividend paying firms.
18. Jones Decorating is currently selling for N50 per share. Jones last paid a dividend of N2
and the growth in dividends and earnings is 10 percent. Based on this data, what is the
required rate of return on Jones?
A. 10.4%
B. 14.0%
C. 14.4%
D. 10.0%
19. Mike Lee’s uncle is a stockbroker and calls him with what he says is a great
opportunity. He is touting a stock that has a current market price of N25. A N2 dividend
was just paid and dividends are expected to grow at a constant rate of 5 percent. Lee’s
required return on investments of this type is 12 percent. Lee should:
A. Not buy the stock; it is overvalued by N5 per share.
B. Not buy the stock; it is overvalued by N3.57 per share.
C. Buy it or not buy it; it doesn’t really matter since the stock is fairly priced.
D. Buy the stock; it is undervalued by N5 per share.
20. High P/E ratios generally indicate that, all else equal, a company will tend to grow:
A. Slowly.
B. Quickly.
C. At the same rate as the market.
D. Not at all.
21. Amina recently paid a N1 dividend on its outstanding common stock. Dividends are
expected to grow at a constant rate of 4 percent. The stock is currently selling for its
fair value price. If shareholders have a required rate of return of 9 percent, what are
the expected capital gains yield and the expected dividend yield for the next year?
A. 0%; 9%
B. 4%; 5%
C. 5%; 4%
D. 9%; 0%
22. All
A.
B.
C.
D.
of the following are underlying assumptions of technical analysis except:
Prices are determined by supply and demand.
Supply and demand is driven only by rational behavior on the part of investors.
Security prices move in trends that persist for long periods of time.
Shifts in supply and demand can be observed in market price behavior.
23. The residual income approach is appropriate when:
A. A firm pays high dividends that are quite stable.
B. A firm does not pay dividends or the payments are too volatile to be sufficiently
predictable.
C. The clean surplus accounting is violated significantly.
D. None of the above.
24. Firms in the latter part of the industry life cycle would be more likely to finance growth
through:
A. Externally generated equity.
B. Internally generated equity.
C. A new debt offering.
D. A new issue of preferred shares.
25. Regina Okon, a portfolio manager, is analyzing the stock of a large consumer durables
manufacturer, XYZ Ltd. Okon has summarized XYZ's business as follows:
XYZ manufactures a limited range of luxury consumer-durable goods. The company
enjoys an excellent reputation for innovation and customer service. Historically, sales
have been strongly correlated with fluctuations in the economy, as sales decline in
economic downturns and increase in economic upturns.
The firm's operations and finances continue to be among the strongest in the industry
with minimal debt, high liquidity, low operating leverage, and a stock beta of 0.85. The
long-run prospects for this company are very strong.
Based on this information, which of the following is true about XYZ company and XYZ
stock?
Company
A. Cyclical
B. Non-cyclical
C. Cyclical
D. Non-cyclical
Stock
Cyclical
Cyclical
Non-cyclical
Non- cyclical
26. A firm has the following per share values:
•
•
•
Cash flow from operation (CFO)
Capital expenditure
Net borrowing
=
=
=
N49.50
N40
N7.50
What is the current per share free cash flow to equity (FCFF)?
A. N17.00
B. N97.00
C. N16.50
D. N25.00
Fixed Income Valuation and Analysis (27 – 40)
27. Which of the following statements is not true?
A. The actual price of a callable bond is lower than or equal to the actual price of a
bullet bond, when all other factors are common.
B. A callable bond protects the investor from a downward shift in the term structure of
interest rates.
C. The return at maturity for an investor in a callable bond which has not been called
earlier is never less than the return at maturity for a bullet bond similar in all
respects except for the call provision.
D. For an investor, a callable bond can be considered as a combination of a long
position in a bullet bond and a short position in a call option on the same bond.
28. An investor holding longer term maturity bonds and not holding any securities with
embedded options would most likely fear interest rates:
A. Increasing.
B. Decreasing.
C. Remaining constant.
D. Moving either way.
29. Which of the following statements concerning a collateralized mortgage obligation
(CMO) is true? A CMO:
A. Eliminated prepayment risk for all classes of investors.
B. Eliminates credit risk for all classes of investors.
C. Redistributes prepayment risk among classes of investors.
D. Reduces prepayment risk for all investors.
30. The liquidity preference theory of the term structure of interest rates combined with the
expectations theory produces a yield curve that tends to be:
A. Flat when interest rates are expected to remain unchanged for the foreseeable
future.
B. Positively sloped most of the time, even though market participants do not always
believe interest rates will increase in the future.
C. Less positively sloped for liquid bonds than the yield curve for liquid bonds when
interest rates are expected to increase in the future.
D. None of the above.
31. Sarah is seeking to purchase a 12-year zero-coupon bond. Assuming semiannual
compounding, if sarah wants to obtain an annual yield of 5.2 percent, how much would
she be willing to pay for the bond?
A. N927.32
B. N627.32
C. N544.27
D. N540.09
32. An 8% annual coupon bond has four years remaining to maturity. Using the following
spot rates, compute the arbitrage-free value of the bond:
Year
1
2
3
4
A.
B.
C.
D.
Spot rates
5
6
6.5
7
N103.39
N103.75
N105.14
We need the YTM to price the bond.
33. A zero-coupon bond has YTM of 10% and matures in five years. What is the convexity
of the bond?
A. 24.79 years.
B. 27.27 years.
C. 4.96 years.
D. 5.00 years.
34. Yinka has been asked by her supervisor to recommend a bond for purchase in a
customer’s portfolio. Yinka has narrowed the decision to four 5-year bonds and has
calculated the OAS for each. Assuming all else is equal, which bond should Yinka
recommend?
A. 5-year putable bond with an OAS of 56
B. 5-year callable bond with an OAS of 62
C. 5-year putable bond with an OAS of 68
D. 5-year callable bond with an OAS of 72
35. What is the purpose of the negative pledge covenant?
A. To keep the firm from issuing any more debt.
B. To keep the firm from issuing any new equity.
C. To keep the firm from issuing debt that is of higher seniority.
D. To keep the firm from selling assets.
36. Which of the following is most likely to affect the analysis of the firm’s ability to repay
the interest and principal components of its debt?
A. The firm’s ability to generate operating cash flows.
B. The character of the firm’s management.
C. The collateral pledged to the debt issue.
D. The level of the company’s debt to total assets ratio.
37. A pension fund is expected to make a perpetual payment of N25,000 p.a. commencing
from the end of year 10. What is the duration of this liability assuming interest rate of
8%?
A. 13.50 years.
B. 22.50 years.
C. 15.50 years.
D. 20.00 years.
38. A portfolio manager has a liability with Macaulay duration of 7.8 years. If the manager
purchases a bond with Macaulay duration of 5.6 years, which of the following is true? If
interest rates:
A. Decrease, the bond portfolio will rise in value by more than the liability.
B. Decrease, the bond portfolio will rise in value by less than the liability.
C. Increase, the bond portfolio will fall in value by less than the liability.
D. Increase, the bond portfolio will fall in value by more than the liability.
39. Which of the following is the most important reason why an immunized portfolio needs
to be adjusted over time?
A. As interest rates change, the duration of assets and liabilities may change causing a
duration mismatch between assets and liabilities.
B. Bonds may be called, which would cause a mismatch between assets and liabilities.
C. Credit spreads may widen, changing the net safety margin of the immunized
portfolio.
D. As interest rates change, the convexity of assets and liabilities may change causing
a convexity mismatch between assets and liabilities.
40. Under the liquidity preference theory, which of the following is the most appropriate
explanation for a flat yield curve?
A. The risk premium for long-term bonds is zero.
B. Future interest rates are expected to rise; however, short-term bonds are perceived
to be riskier than long-term bonds.
C. Future interest rates are expected to decline; however, long-term bonds have a
higher risk premium than short-term bonds.
D. Under the liquidity preference theory, the yield curve always has a positive slope
and cannot be flat.
Total = 40 marks
Question 2 – Corporate Finance
Virtually all debt contracts contain covenants to restrict the activities of managers acting on
behalf of shareholders from expropriating wealth from lenders. List and briefly explain any 3
of these covenants.
(3 marks)
Question 3 – Equity Valuation and Analysis
XY Ltd is planning to acquire a slower-growth competitor, which will materially increase XY’s
sales volume. The company to be acquired has pretax margin that are approximately the
same as those of XY Ltd. XY Ltd plans to issue N750 million in long-term debt to finance the
entire cost of the acquisition.
Required:
Give three possible reasons why the acquisition might decrease the valuation of XY Ltd
(3 marks)
Question 4 – Fixed Income Valuation and Analysis
You are the head of the fixed income unit of your bank. You plan to invest N500m in either
bond A or bond B, with the details given below, for a period of 2 years. You believe that
interest rates could move substantially in either direction in the next two years.
Bond A
Bond B
Coupon rate
6%
5%
8%
7.5%
Maturity
10 years
6 years
YTM
Required:
Using your knowledge of convexity, explain which of the bonds you would buy, holding other
factors constant (No calculation is required).
(4 marks)
Question 5 – Corporate Finance
Yinko Ltd is a family business operating in the fast food industry. The family owns 80% of the
shares. The remaining 20% is owned by five non-family shareholders. The board of directors
is considering an investment involving manufacturing a new brand of soft drink- Yincola. The
directors are considering the viability of the project on a ‘trial’ basis for the next five years.
The net, post-tax operating cash flows of the investment are estimated as:
Year 0
Year 1-4
Year 5
- N25m (initial outlay)
N6.30m each year
N11.70m (includes scrap value)
The company normally uses 12% to evaluate capital investments. However, this investment
is different from its usual business operations and the directors suggest using CAPM to
determine the appropriate discount rate. Yinko Ltd, being unlisted does not have a published
beta, so the Finance Director has obtained an equity beta of 1.40 for a soft drink company
that is listed. The company has a debt ratio (debt to total assets) of 40%.
Yinko Ltd has financial leverage advantage–also called equity multiplier (i.e. total asset to
equity) of 1.40 times. The risk-free interest rate is 8% and the market risk premium is 8%.
Corporate tax rate is 25% and corporate debt can be assumed to be risk free.
5(a) Compute the relevant asset beta for the new project.
(3 marks)
5(b) Compute the relevant equity beta for the project.
(3 marks)
5(c) Estimate an appropriate discount rate to be used for the new project (Round up your
answer to the nearest %).
(4 marks)
5(d) Using net present value method, is the project viable?
(Note: If you could not correctly calculate an appropriate discount rate in 5(c) above
assume a rate of 15%)
(4 marks)
5(e) Give two major problems associated with the use of Proxy Company’s beta in
computing the relevant cost of capital for project.
(2 marks)
Question 6 –Equity Valuation and Analysis
6(a) Crespo Palms plc is a Nigerian company engaged in the production and export of palm
oil. Its earnings per share (EPS) have increased from N35 in 2007 to N100 in 2012. The
stock currently trades at N2,700 on the Nigerian Stock Exchange. Crespo Palms plc
follows a dividend policy of 30% payout and has managed a ROE of 30% for the year
2012. Assume that the cost of equity is 25%.
Required:
What should be the calculated current share price of Crespo Palms plc if the company
would stop growing from 2012 onwards? Looking at the current share price of N2,700 ,
what do you conclude regarding the market's expectation on Crespo Palms plc?
(3 marks)
6(b) What should be the current calculated share price of Crespo Palms plc if the future
growth rate would be equal to the average growth rate during the past 5 years?
Looking at the current share price of N2,700, what do you conclude regarding the
market's expectation on Crespo Palms plc?
(3 marks)
6(c) Calculate the share price of Crespo Palms plc using the Gordon Shapiro model (which
assumes g = rb). Comment on the calculated price in relation to the market price
assuming that the future ROE is expected to be maintained at 30%. Explain briefly what
the growth rate of the Gordon Shapiro model reflects.
(3 marks)
6(d) Briefly explain how and why the multiple growth models differ from the constant growth
model?
(2 marks)
6(e) Crespo has a large amount of cash on hand and plans to make an acquisition. It has
Identified a target company with a market capitalization of N10 billion. This company
would generate free cash flows of N1.0 billion in year 1 after the acquisition. After that
the free cash flow is expected to grow by 10% each year until year 5. Crespo is
confident to sell the acquired business at the end of year 5 for N15 billion. Should
Crespo go ahead with the acquisition if the discount rate is 7%? Justify your answer by
calculating the NPV.
(5 marks)
Question 7 – Fixed Income Valuation and Analysis
You have just resumed at an asset management firm as the head of the Fixed Income Unit.
You were immediately confronted with a number of decisions/challenges.
7(a) It is June 30, 2012. Your company is considering purchasing one of the following newly
issued 10-year AAA corporate bonds shown in the following table. You note that the
yield curve is currently flat and you assumed that the yield curve shifts in an
instantaneous and parallel manner:
Description
A (due June, 30
2022)
Coupon
6.00%
B (due June 30,
2022)
6.20%
Bond Characteristic
Price
Callable
100.00
Non-callable
100.00
Currently
callable
Call price
Not applicable
102.00
7a1) Contrast the effect on the price of both bonds if yields decline more than 100
basis points (No calculation is required).
(3 marks)
7a2) State and explain under which two interest rate forecasts you would prefer Bond B
over Bond A.
(2 marks)
7a3) State the directional price change, if any, assuming interest rate volatility
increases, for each of the following:
I)
Bond A.
(1 mark)
7a3) II) Bond B.
(1 mark)
7(b) Next, your Economic Unit has come up with the following data from prices of zerocoupon bond.
Year
1
2
3
Forward Rate
5%
7%
8%
Required:
7b1) Compute the spot rates for each of the years.
(3 marks)
7b2) You are looking at the possibility of purchasing a 3-year bond making annual
payments of N60 with par value of N1,000. You plan to hold the bond till maturity.
Required:
I)
Compute, using the forward rates or otherwise, the price of the bond.
(3 marks)
7b2) II) What is the YTM of the bond.
(3 marks)
7b2) III) Compute the current yield of Bond B. What is the weakness of this
yield measure?
(3 marks)
FORMULAE
Levered/unlevered beta:
Annuities:
Yield to maturity of a bond:
Valuation of perpetual bonds:
Price change approximated with duration:
Portfolio duration:
Macaulay duration: