CIS March 2012 Exam Diet
Examination Paper 2.2:
Corporate Finance
Equity Valuation and Analysis
Fixed Income Valuation and Analysis
Level 2
Corporate Finance (1 – 13)
1.
Which of the following statements about net working capital (NWC) is not correct?
A. NWC is defined as: Cash + other current assets – current liabilities.
B. Firms with a flexible short-term financing policy are expected to have a relatively
high NWC.
C. If maturities are strictly matched (i.e. current assets are financed only by shortterm debt, and fixed assets only by long-term debt and equity), the NWC would
always be zero.
D. The smaller the NWC the less likely the risk of illiquidity, all things being equal.
2.
Which of the following statements referring to the Modigliani-Miller (M/M) proposition
without taxes is true (ceteris paribus)?
A. A greater leverage leads to a greater beta on the stock market.
B. According to M/M the substitution of equity capital with debt capital lowers the
WACC of a corporation because debt capital is cheaper than equity capital.
C. An increase in leverage lowers the risk carried by the shareholders.
D. By increasing the leverage the value of a firm can be increased.
3.
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.
4.
Consider the following data for a company: Earnings per share (EPS) is N40, the
sustainable rate of growth (g) is 2%, cost of equity (ke) is 10% and return on equity
(ROE) is 8%. What is the payout ratio of the company’s earnings?
A. 0
B. 0.75
C. 1
D. 0.4
5.
A firm has a capital budget constraint of N5,000,000 and has the following
independent investment options:
Project
Outlay (N’ 000)
NPV (N’ 000)
I
3,000
1,200
II
2,000
900
III
2,000
840
IV
1,600
1,000
V
1,400
600
The firm would invest in:
A.
B.
C.
D.
Projects
Projects
Projects
Projects
I & II only.
I & III only.
II, IV & V only.
III, IV & V only.
6.
A company reports an EBIT of N1,500,000 and is in a tax bracket of 30%. The
company is partly debt financed and the debt is valued at N10,000,000. If the cost of
capital of the unlevered firm is 12% and the firm has 1,000,000 shares outstanding,
what is the market price of one share (assuming efficient and arbitrage-free
markets)?
A. N1.65
B. N1.70
C. N1.75
D. N1.80
7.
Which of the following factors would encourage a company to maintain a high
dividend payout ratio?
A. The company is in the early stage of its life cycle.
B. The double-taxation system is in place in the company's home country.
C. Most of the shares in the company are held by income-oriented mutual funds.
D. The company's debt covenants require an interest coverage ratio of at least 2.0
times.
8.
Which of the following is the least appropriate method for estimating a firm’s beforetax cost of debt capital?
A. Use the market yield on bonds with a rating and maturity similar to the firm’s
existing debt.
B. Assume the firm’s cost of debt capital is equal to the yield to maturity on its
publicly traded debt.
C. Use the coupon rate on the firm’s most recently issued debt.
D. None of the above.
9.
Which of the following is not a pre-offer takeover defence mechanism?
A. Poison pills.
B. Shark repellents.
C. Golden parachutes.
D. Greenmailing.
10. Which of the following statements is true with respect to the consequences of a
merger?
A. The cost of an acquisition may be found by subtracting the sum of the present
values of the entities on a stand-alone basis from the present value of the
entities as a combined unit.
B. A merger diversifies the operations of the company as a whole, thus the
resulting reduction in risk will cause the stock to trade at a premium.
C. Generally, the tax consequences to the target company’s shareholders are the
same irrespective of whether the acquisition is for cash or for the shares of the
acquiring firm.
D. If an acquiring company purchases a target company that is trading at a lower
P/E than itself, then the EPS of the combined entity will always increase.
11. In the beginning of the year, BC Limited issued 22,000 warrants at N5 apiece. Each
warrant may be converted into one ordinary share at an exercise price of N15. The
share has a par value of N2 and is currently priced at N17. If the warrants are
exercised in the middle of the year, which of the following statements would be
false:
A. At the time of exercise, paid up capital will increase by N330,000.
B. The total cash that is generated during the year as a result of these warrants is
N440,000.
C. At the time of exercise, the number of shares outstanding will increase by
22,000.
D. All of the above
12. ABC Limited buys materials from its suppliers on eight weeks’ credit. The materials
are delivered immediately and held for two weeks before being issued to production.
The production process takes five weeks and the finished goods are held for six
weeks before being sold. All customers are allowed six weeks’ credit but take seven
weeks to pay.
How long is the operating cash cycle of the business?
A. 8 weeks.
B. 10 weeks.
C. 12 weeks.
D. 16 weeks.
13. Which of the following statement(s) about asset-backed securities (ABS) is/are
correct?
A. ABS are securities which are backed by cash flows from a variety of financial
assets.
B. The process of creating ABS is called capital enhancement.
C. An ABS always has considerably higher credit risk compared with the financial
assets backing the security.
D. (A) and (C) only.
Equity Valuation and Analysis (14 – 26)
14. The risk-free rate is 5% and the expected return on the market index is 15%. A
stock has a:
•
Beta of 1.0
•
Dividend payout ratio of 40%
•
Return on equity (ROE) of 15%
If the stock is expected to pay a N2.50 dividend, its intrinsic value using dividend
discount model is:
A. N27.77
B. N41.67
C. N53.33
D. N17.77
15. Which valuation measure is most likely more difficult to interpret when inflation has
been high?
A. Price/sales.
B. Price/earnings.
C. Price/book value.
D. None of the above.
16. A stock that currently does not pay a dividend is expected to pay its first dividend of
N1.00 five years from today. Thereafter, the dividend is expected to grow at an
annual rate of 25% for the next three years and then grow at a constant rate of 5%
per year thereafter. The required rate of return is 10.3%. The value of the stock
today is closest to:
A. N20.65
B. N22.72
C. N23.87
D. N24.72
17. Given the information below, compute the Economic Value Added of CBA Limited:
Net operating profit after tax:
Beginning book value of debt:
Beginning book value of equity:
WACC:
A. N45
B. N67
C. N78
D. N95
N100
N200
N300
11%
18. Which of the following describes the flow of the top-down valuation process?
A. Economic analysis, industry analysis, company analysis.
B. Company analysis, industry analysis, economic analysis.
C. Economic analysis, company analysis, industry analysis.
D. Pick the best stocks regardless of the industry and economic conditions.
19. An analyst used the infinite period dividend discount valuation model to determine
that XYZ Limited should be valued at N20. The current market price is N30. The
analyst should do which of the following?
A. Issue a buy recommendation on XYZ.
B. Issue a sell recommendation on XYZ.
C. Issue a hold recommendation on XYZ.
D. Do nothing since the results conflict each other.
20. A manufacturing company is expected to have before-tax cash flow from operations
of N750,000 in the coming year. The firm's corporate tax rate is 40%. It is expected
that N250,000 of operating cash flow will be invested in new fixed assets.
Depreciation for the year will be N125,000. After the coming year, cash flows are
expected to grow at 7% per year. The appropriate market capitalization rate for
unleveraged cash flow is 13% per year. The firm has no outstanding debt. What is
the projected free cash flow of the company for the coming year?
A. N250,000
B. N180,000
C. N300,000
D. N380,000
21. What is market value added (MVA)? It is:
A. Net operating profit after taxes less capital charge.
B. Free cash flow to the firm adjusted for abnormal earnings.
C. Free cash flow to equity.
D. It is the present value of all future economic value added (EVAs).
22. Return on equity using the traditional DuPont formula equals:
A. (net profit margin) X (interest component) X (solvency ratio).
B. (net profit margin) X (total asset turnover) X (tax retention rate).
C. (net profit margin) X (total asset turnover) X (financial leverage multiplier).
D. None of the above.
23. During the late expansion phase of the business cycle, which of the following would
be the most attractive investment?
A. Real estate.
B. Commodities.
C. Cyclical stocks.
D. Interest sensitive stocks.
24. Which of the following is not one of Porter's "five factors" that determine the
intensity of industry competition?
A. Threat of government regulation.
B. Threat of substitutes.
C. Rivalry among competitors.
D. The bargaining power of buyers.
25. Which of the following statements is false? A speculative:
A. Stock is usually underpriced.
B. Company has highly risky assets.
C. Company can be over or undervalued.
D. Stock has a low probability of earning a market rate of return.
26. Which of the following least accurately describes the advantages of valuation with
the P/E multiple?
A. P/E ratio is popular in the investment community.
B. P/E differences are significantly related to long-run average stock returns.
C. Earnings power is the primary determinant of investment value.
D. P/E valuation can accommodate negative earnings.
Fixed Income Valuation and Analysis (27 – 40)
27. A coupon bond pays annual interest, has a par value of 1,000, matures in 12 years,
has a coupon rate of 5%, and has a yield to maturity of 6%. The current yield of this
bond is:
A. 4.54%.
B. 5.00%.
C. 5.46%.
D. 6.00%.
28. Which of the following statements is most accurate with regard to floating-rate
issues that have caps and floors?
A. A cap is an advantage to the bondholder, while a floor is an advantage to the
Issuer.
B. A floor is an advantage to the bondholder, while a cap is an advantage to the
Issuer.
C. A floor is an advantage to both the issuer and the bondholder, while a cap is a
disadvantage to both the issuer and the bondholder.
D. None of the above.
29. Which of the following statements least accurately describes a form of risk associated
with investing in fixed income securities?
A. Credit risk has only two components, default risk and downgrade risk.
B. Other things equal, a bond is more valuable to an investor when it has less
liquidity risk.
C. Bonds that are callable, pre-payable or amortizing have more reinvestment risk
than otherwise equivalent bonds without these features.
D. None of the above.
30. Which of the following statements is true with respect to the types of extra features
that may be incorporated into a bond?
A. Put provisions allow the holder of the bonds to deliver the underlying bond to the
issuer in exchange for some predetermined price.
B. Exchangeable bonds allow the holder to exchange the bonds for the common
shares of the underlying issuer.
C. Indexed amortization notes allow the issuer to accelerate principal repayments if
a specified reference interest rate increases.
D. Callable bonds allow the issuer to deliver another bond to the holder in place of
the original issue when interest rates fall.
31. A zero coupon bond, maturing in 4 years and 3 months at par is currently quoted at
70.70%. Due to a deterioration of the business conditions for the issuer, the credit
rating of the bond issuer now gets downgraded. You expect a change of 100 basis
points in the yield to maturity for the bond. According to you, the bond should now
be quoted at:
A. 66.5%.
B. 68.0%.
C. 72.0%.
D. 73.5%.
32. A bond manager believes that interest rates are going to decrease. As a result, the
manager moves out of short-duration bonds and into long-duration bonds. This
manoeuvre is an example of:
A. Substitution swap.
B. Rate anticipation swap.
C. Inter-market spread swap.
D. Pure yield pickup swap.
33. Which of the following statements is false regarding bond immunization?
A. Immunization means that an investor has to sell a part or the whole of his
portfolio and buy other securities so that the duration of the new portfolio
coincides with the investor’s investment horizon.
B. This is the strategy of matching the bond‘s duration with the time horizon of the
investor.
C. Investor’s can protect themselves from the interest rate risk through bond
immunization.
D. Immunization will provide a compound rate of return over the period immunized
that equals the bond‘s yield to maturity, irrespective of changes in market rates.
34. Which of the following statement about bond convexity is incorrect?
A. Convexity is generally beneficial to the investor.
B. Convexity changes with time.
C. A bond with smaller convexity should be preferred, all other things being equal.
D. When yields fall, a bond with larger convexity will have a higher price than one
with smaller convexity.
35. An investor is currently examining the following treasury data:
Maturity
Coupon
Rate
Price
Yield-to-maturity
1-year
0
98.09
3.90%
2-year
0
95.74
4.40%
3-year
4.7%
100.00
4.70%
What is the investor’s best estimate of the 3-year spot rate?
A. 4.25%
B. 4.33%
C. 4.72%
D. 4.91%
36. Bond D is selling for N1,050, its yield to maturity is 8%, and its duration is 9 years.
What will be the price of Bond D if yield to maturity decreases to 7.84%?
A. N1,020
B. N1,064
C. N1,073
D. N1,082
37. An analyst has noticed lately that the price of a particular bond has risen less when
the yield falls by 0.1% than the price falls when rates increase by 0.1%. She could
conclude that the bond:
A. Is an option-free bond.
B. Has an embedded put option.
C. Has negative convexity.
D. None of the above.
38. Which of the following is true with respect to credit-linked notes?
A. They are issued as zero coupon bonds.
B. They are bonds that return the par value to the investor in the event of default
or downgrade.
C. They are bonds that pay a higher coupon rate to the investor compared with
similar bonds with no credit linkage.
D. They are bonds that can be put back to the issuing firm in the event of a default
or downgrade.
39. Which of the following statements least accurately describes overcollateralization in
the context of collateralized debt obligations (CDOs)?
A. Overcollateralization is a form of internal credit enhancement.
B. Overcollateralization occurs when too much collateral is used.
C. Overcollateralization of senior tranches is greater than for junior tranches.
D. None of the above.
40. A portfolio manager is currently constructing a bond portfolio by purchasing the
following bonds:
Duration
Bond A
Bond B
Bond C
3.8
5.7
1.9
Market Value
N
220,000
1,000,000
570,000
Which of the following best estimates this portfolio's duration?
A. 3.68
B. 4.26
C. 4.89
D. 3.80
Total = 40 marks
Question 2 – Corporate Finance
Explain briefly, the principal problem involved in using the dividend valuation model to
value the following types of companies:
(Note: assume that the companies pay dividends).
2(a1)
Companies whose operations are closely correlated with the economic cycles.
(1½ marks)
2(a2)
Companies that are of small size and are growing rapidly.
(1½ marks)
Question 3 – Equity Valuation and Analysis
What do you understand by Economic Value Added (EVA)? Briefly explain its use in the
valuation of equities.
(3 marks)
Question 4 – Fixed Income Valuation and Analysis
Mention and briefly discuss two key issues that should be of interest to an investor,
normally taken into consideration in bond rating.
(4 marks)
Question 5 – Corporate Finance
The management of Technohob Limited, a technology company is considering a new
project. The life cycle of the new product is expected to be 5 years due to the rapid
technological changes in the industry. The revenue projections and cost structures of the
project are provided below:
I.
Initial investment of N15 million is required for the equipment.
II. After-tax incremental revenues of N2.5 million for the first year, of N3.0 million for
the second year and N3.5 million for the third year are expected. For year 4 and 5 the
annual incremental revenue is expected to decrease by N0.5 million each year.
III. After-tax cost savings are expected to be N1.5 million in the first year. They are then
expected to increase by 5% every year.
IV. Annual depreciation tax shield of N1.05 million will arise throughout the project.
The applicable discount rate is 12%.
Required:
5(a1)
Compute the project’s Net Present Value
(7 marks)
5(a2)
Compared with IRR, why is NPV considered a superior project appraisal technique?
(2 marks)
5(b1)
Global Supplies Limited, a Nigerian company based in Lokoja is in a stable, no
growth situation. It has 100,000 units of 10% perpetual debentures that currently
sell at par value of N100/unit. The company’s earnings before interest and tax
(EBIT) is N5,000,000, its cost of equity is 15%, and it has 100,000 shares
outstanding. The company’s payout ratio is 100%. Assuming a tax rate of 30%,
calculate the theoretical price of the stock, using the dividend discount model.
(5 marks)
5(b2) Compute the weighted average cost of capital (WACC) of Global Supplies
Limited, using the market value basis. (If you did not solve 5(b1) you can use
a price of N100/unit for the equity of Global Supplies Limited).
(2 marks)
Question 6 –Equity Valuation and Analysis
PolyExperts Limited is a successful manufacturer of rubber products in Eastern Nigeria.
Since the Initial Public Offering (IPO), that took place one year ago, the increase in stock
price has been impressive. Growth was fostered by an intensive program of investments
aimed at extending its international network thereby tapping foreign markets. So far the
company has been all-equity financed and the internally generated funds were large
enough to finance all new projects. At the end of 2011, PolyExperts is planning to
undertake the acquisition of a company that maintains vast rubber plantations across the
country. A consultant working with the company in its expansion plans would like to
evaluate PolyExperts.
The following tables show the income statements of PolyExperts, the planned capital
expenditures ("CAPEX") (net of disposals) and the net working capital ("NWC").
Table 1. PolyExperts actual and projected income statements (in millions of Naira).
2011A
2012E
2013E
2014E
400
450
550
670
-190
-200
-240
-290
Advertising
-30
-35
-40
-55
Selling costs
-20
-20
-30
-30
Administrative expenses
-60
-70
-80
-90
EBITDA
100
125
160
205
Depreciation
-20
-20
-25
-30
EBIT
80
105
135
175
Taxes
-24
-31.5
-40.5
-52.5
56
73.5
94.5
122.5
Sales
Cost of sales
Net income
Table 2. PolyExperts capital expenditure and net working capital (in millions of Naira).
CAPEX
NWC
2010A
20
40
2011E
30
50
2012E
25
90
2013E
40
110
To estimate the cost of capital of PolyExperts, the consultant has computed the beta of
shares of peer companies comparable to PolyExperts with respect to the systematic risk of
operating cash flows. The equity beta of these peers equals 1.1. Unlike PolyExperts, peer
companies on average have a leverage ratio (D/E) of 1/3 and debt can be considered
riskless. The risk free rate is 4% and the market risk premium is 7%.
6(a)
Assuming a tax rate of 30%, estimate the free cash flow to the firm (FCFF) of
PolyExperts for years 2012, 2013 and 2014.
(7 marks)
(Use the table below for the calculations).
Cash flow (in millions of Naira)
Free Cash Flow
to the Firm
6(b) Calculate the cost of capital of PolyExperts. Assume a tax rate of 30%.
(4 marks)
6(c)
Assume that the free cash flow of PolyExperts would grow at the rate of 2% into
perpetuity after 2014, and that there are 100 million shares outstanding.
6(c1)
Determine the value of the company.
(3 marks)
6(c2)
Calculate the price per share.
(2 marks)
Question 7 – Fixed Income Valuation and Analysis
7(a) In the table below, you have the market yield for a zero coupon bond with which you
have created a yield curve. You are required to fill in the cells labeled A, B, C, and D
with missing details, showing all your calculations. All figures should be rounded to
four decimal places.
Maturity
1 Year
2 Years
3 Years
C
Zero-coupon bond yield
2.5000%
3.120%
A
Zero-coupon bond price
0.9404
0.8988
D
Forward 1 year Interest rate
4.627%
2.5000%
Duration
1
2
3
1.9395
2.8952
B
Modified duration
(7 marks)
7(b)
Bond X has a semiannual 13% coupon, has a N1,000 par value, and matures in
30 years.
Find below a graph plotting the price of bond X against its yield to maturity ranging
from 2%, 4%, 6% and so on, up through 20%. Price is on the vertical axis while
yield is on the horizontal axis.
Bond Price vs. Yield
4,000
3,500
Bond Price ($)
3,000
2,500
2,000
1,500
1,000
500
0%
5%
10%
15%
20%
25%
Yield to Maturity
7(b1) From the above figure, identify two key features of the bond price-yield
relationship.
(3 marks)
7(b2) Estimate the price of bond X when yield is 10%.
(No calculations required).
(2 marks)
7(b3) The graph in 7(b) above is for a bond that has no embedded option. Illustrate the
shape of the bond price-yield relationship for a callable bond and explain the
implication of this to an investor. (Graphical illustration only is required; no need
to draw to scale).
(3 marks)
Bond price
Yield to maturity
7(b4)
Because of financial stress, Bond X was downgraded by Moody’s from A to BBB.
What is the predicted effect on the bond’s price and the bond’s yield to maturity?
(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: