CHARTERED INSTITUTE OF
STOCKBROKERS
ANSWERS
Examination Paper 2.2
Corporate Finance
Equity Valuation and Analysis
Fixed Income Valuation and Analysis
Professional Examination
March 2013
Level 2
1
SECTION A: MULTI CHOICE QUESTIONS
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
D
D
C
C
A
B
D
C
D
D
A
B
C
A
B
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
B
C
C
D
B
B
B
B
B
C
A
B
A
C
B
31
32
33
34
35
36
37
38
39
40
D
B
A
D
C
A
B
B
A
C
(40 marks)
SECTION B: SHORT ANSWER QUESTIONS
Question 2 – Corporate Finance
(i) Asset covenant – Governs the company’s acquisition, use, and disposition of assets
(ii) Dividend covenant – An asset covenant that restricts the payment of dividends
(iii) Financial covenant – Description of the amount of additional debt the firm can
issue and the claims to assets that this additional debt might have in the event of
default
(3 mark)
Question 3 – Equity Valuation and Analysis
The constant – growth rate dividend model is given by:
D1
P0 =
r-g
XY’s acquisition of a slower growth competitor might decrease its valuation for the
following reasons:
(i)
XY’s N750 million in new long-term debt and related interest costs
decreases the likelihood that the dividend will be increased next year (D1).
(ii)
The acquisition of a slower-growth company reduces the acquirer’s longterm growth rate of dividends (g);
(iii)
The higher financial leverage resulting from the acquisition will increase
the perceived riskiness of XY, raising investors’ required rate of return (k)
(iv)
Everything else being equal, these factors (lower dividend growth rate and
higher required rate of return) could interact to increase the denominator
and decrease the numerator of the DVM
(1 mark each, subject to maximum of 3 marks)
Question 4 – Fixed Income Valuation and Analysis
2
I will buy Bond A because it has a higher convexity:
• Lower YTM
• Lower Coupon
• Longer maturity
Bond with higher convexity is preferred in all interest rate situations. If rates rise, the
price will fall at a slower rate and if rates fall, the price will rise at a faster rate.
Total = 4 marks
SECTION C: ESSAY TYPE/CALCULATIONS
Question 5 – Corporate Finance
5(a)
Since debt is risk-free, beta of asset can be computed using the following formula:
BE VE
, where
BA =
VE + VD(1-t)
=
beta of equity – in this case for the proxy company = 1.40
BE
=
value of equity of the proxy company
VE
=
value of debt for the proxy company
VD
t
=
effective tax rate for the proxy company
We however need to determine VE and VD. With debt ratio of 40%
VD
= 0.40
VE + VD
This means that debt is 40% of total asset and equity is 60%
1.40 x 60
BA =
= 0.9333
60 40(1-0.25)
(3 marks)
5(b)
The above asset beta should be ‘geared’ up to reflect the financial risk of Yinko. This
means converting the asset beta to equity beta – using the leverage ratio of Yinko.
BE = BA + (BA - BD) (D/E) (1 - t)
But we are told that:
Total assets
= 1.40
Equity
E+D
= 1.40
E
1.40E = E + D
D=
0.40E
This means that debt is 40% of equity or D: E = 40:100
Thus:
= 1.21
βE = 0.9333 + (0.9333 - 0) (40/100) (1.025)
(3 marks)
5(c)
3
Since the company (Yinko) is geared, the appropriate discount rate to use is the WACC.
First, we compute cost of equity (KE)
=
RF + B (Rm - Rf)
KE
=
8 + 1.21 (8) = 17.68
Next, we compute cost of debt, net of tax. We must assume cost of debt of 8% - since
we are told that debt is risk- free.
=
8 (1 – 0.25) = 6%
KD
Next, we compute the WACC.
WACC
= (100 x 17.68) + ( 40 x 6) = 14%
140
140
5(d)
The viability of the project is best assessed using NPV method.
Item
year
NCF
PVF at
14%
Nm
Outlay
0
(25)
1
Inflow
1- 4
6.30
2.914
Inflow
5
11.70
0.519
NPV
PV
Nm
(25)
18.358
6.072
(0.570)
Recommendation: The project is not viable because the NPV is negative.
5(e)
(i) The proxy is unlikely to be fully representative of Yinko’s new project.
(ii) Beta factor is also affected by operating leverage, that is, the relationship between
fixed and variable operating costs which may not be the same for the two companies.
(iii) The relevance of the CAPM to the cost of capital of an unquoted company is doubtful.
The model assumes that shareholders eliminate unsystematic risk by holding
diversified portfolios. The shareholders of Yinko probably do not hold large portfolio
outside their investment in Yinko. Hence the investment’s total risk may be more
relevant than its systematic risk.
(2 marks)
Question 6 – Equity Valuation and Analysis
6(a)
The dividend at 30% of EPS is 30. Hence, using the zero growth model:
Price =
= 30/ 0.25 = N120
Dividend
Cost of equity
The market definitely expects a large positive growth from the stock.
6(b)
(3 marks)
4
For the past five years, the average EPS growth rate works out to 23.36%:
Growth Rate in EPS = (100/35)1/5 - 1
= 23.36%
Since the company follows a constant dividend payout of 30% the rate of dividend
growth is also the same at 23.36%. Now, using the constant growth model, we can
calculate the price as:
MV = DO ( 1 + g)
KE – g
= 30 (1 +0.2336)
0.25 – 0.2336
= N2,256.6
The price, assuming that the constant growth of the past 5 years would continue, is
N2,256.6. This is less than the current market price. It implies that the market is
expecting a higher growth rate in the future.
(3 marks)
6(c)
Using the Gordon Shapiro model:
g= rb = ROE(1-0.3) = 0.3(1-0.3) = 0.21
MV = DO ( 1 + g) = (100 X 0.3)(1 +0.21) = 36.3 = N907.50
0.25 – 0.21
0.04
KE – g
The stock seems to be clearly overvalued by the market.
According to the Gordon Shapiro model the growth rate is the product of the ROE and
the earnings retention ratio, i.e. the returns generated on the retained funds.
(3 marks)
6(d)
A constant growth model assumes a fixed growth rate for a stock in the future. Firms
typically go through life cycles, with growth varying with the age of the firm. As growth
varies, so may the dividends. The multiple growth model allows dividends to follow
different growth patterns. The analyst could for instance forecast the first few dividends
separately and assume a constant dividend growth model thereafter. He might be able
to forecast individual near term dividends with some precision; for later dividends, he
might just be able to make an average prediction. The multiple growth model allows for
different stages of growth reflecting the life cycle of a company.
(2 marks)
6(e)
5
The free cash flows from the investment will be as follows:
FCF
Discount factor @ 7%
Investment
10,000,000,000
Year 1
1,000,000,000
Year 2
1,100,000,000
Year 3
1,210,000,000
Year 4
1,331,000,000
Year 5
1,464,100,000
Terminal Value 15,000,000,000
1
0.9346
0.8734
0.8163
0.7629
0.7130
0.7130
Present value
-10,000,000,000
934,579,439
960,782,601
987,720,431
1,015,413,527
1,043,883,065
10,694,792,692
Note that we have used 7% as the discount rate.
The NPV for the investment is the sum of the present values and is equal to 5,637,171,756,
which is positive. Hence, Infosys should go ahead with the acquisition.
Question 7 – Fixed Income Valuation and Analysis
7(a1)
As interest rates decline, the price of both bonds would increase. However, the price
appreciation of Bond B will be limited by the call price of 102.00. As interest rate decline,
the probability of the issuer calling the bonds increases, as the company will consider
issuing new bonds at lower interest rates. On the other hand, the price appreciation of
Bond A would not be limited. On the other hand, the price appreciation of Bond A would
not be limited, as the bond is not callable. Therefore, bond A would be the preferred
investment if you expect interest rates to decrease by more than 100 basis points.
7(a2)
You should prefer the Bond B in either a rising or a stable interest rate scenario. The
Bond B has an embedded option, which is sold by the investor to the issuer of the bond.
The higher yield compensates you for the risk of being short the embedded call option. If
rates are stable or increase, the investor earns the extra income without having to worry
about having the bond called from them. Additionally, if rates increase, bond B price
should decrease less relative to bond A because of bond’s shorter effective duration due
to the embedded call option.
7(a3)
Since the Bond A is non-callable, increased interest rate volatility would not impact its
directional price change.
Callable bond value = Non-callable bond value – Call option value
The level and volatility of interest rates are key factors in determining the value of a
bond with an embedded call option. The greater the variance or uncertainty of interest
rates, the greater the value of the embedded call option. As the embedded option value
increases, it causes the value of bond B to decrease.
7(b1)
6
Spot rates and forward rates are related as follows:
=
Fn,m
-
M-n
(1 + R0,n)n
Where
=
Fn,m
1
forward rate from year n to year m
=
Ro,m
1
(1 + R0,m)m
spot rate from year o to year m
Year 1:
Fn,1
Year 2:
F1,2
=
=
Ro,m
(1 + R0,2)
=
5%
2
-1
(1 + R0,1)
1.07
=
(1 + R0,2)2
Year 3:
(1 + R0,3)3
R0,3
(1 + R0,2)2
1.05
=
1.07 x 1.05
(1 + R0,3)3
F2,3
=
1.08
=
=
(1.08) (1.06)2
=
(1.08) (1.06)2
or
R0,2
=
6%
=
984.0581
- 1
(1 + R0,2)2
(1 + R0,3)3
(1 + 0.6)2
1
3
-1
=
6.6625%
7(b2)
I) using forward rates
N
Yr 1
60 / 1.05
=
Yr 2
60 / 1.50 x 1.07
=
53.4045
=
873.5928
984.14020
Yr 3
1060 / 0.05 x 1.07 x 1.08
Price (Po)
57.1429
Or using sport rate
P0
II)
=
60
+
1.05
60
(1.06)
2
1060
+
(1.066625)2
The YTM is given by the value of K in the following equation.
984.581.1
OR
=
60
I+K
+
60
(I + K)
+
2
1060
(I + K)3
===
6.60%
From your financial calculator:
FV
1060,
PMT
60,
n
3,
PV 984.1402
7
CPT
1/y
=
6.60
Otherwise, use interpolation
III)
Current Yield of Bond B
Annual Coupon
Current Market Price
= 6.20% X 100
= N6.20
100
This measure is not an accurate reflection of the actual return that an investor
will receive in all cases, because bond prices are constantly changing due to
market factors.
8