CHARTERED INSTITUTE OF
STOCKBROKERS
ANSWERS
Examination Paper 2.2
Corporate Finance
Equity Valuation and Analysis
Fixed Income Valuation and Analysis
Professional Examination
March 2012
Level 2
1
SECTION A: MULTI CHOICE QUESTIONS
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
D
A
D
B
C
C
C
C
D
D
A
C
A
B
C
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
A
A
A
B
A
D
C
D
A
A
D
C
B
A
A
31
32
33
34
35
36
37
38
39
40
B
D
A
C
C
B
C
C
B
B
(40 marks)
SECTION B: SHORT ANSWER QUESTIONS
Question 2 – Corporate Finance
2(a1)
A company whose operations are closely correlated with economic cycles would
experience fluctuations in its dividend growth rates. Therefore the assumption of
constant growth in dividends (which is fundamental to the dividend valuation model) is
unrealistic for a company that is subject to cyclical swings in its business.
(1 ½ marks)
2(a2)
Similarly, small, rapidly growing companies are not able to sustain above average rates
of growth indefinitely. Therefore the high growth of earnings currently being experienced
is inconsistent with the assumption of the infinite period constant growth dividend
valuation model.
(1 ½ marks)
Total = 3 marks
2
Question 3 – Equity Valuation and Analysis
Economic Value Added (EVA) is a measure of a company's financial performance based
on the residual wealth calculated by deducting cost of capital from its operating profit
(adjusted for taxes on a cash basis). It is also referred to as "economic profit".
The formula for calculating EVA is as follows:
= Net Operating Profit After Taxes (NOPAT) - (Capital * Cost of Capital)
(1 ½ marks)
EVA is related to the concept of Market Value Added (MVA), which is very useful in
equity valuation.
MVA shows the difference between the market value of a company and the capital
contributed by investors (both bondholders and shareholders). In other words, it is the
sum of all capital claims held against the company plus the market value of debt and
equity. It is calculated as: MVA = Market value –invested capital.
The higher the MVA, the better for the firm. A high MVA indicates the company has
created substantial wealth for the shareholders. A negative MVA means that the value of
management's actions and investments are less than the value of the capital contributed
to the company by the capital market (or that wealth and value have been destroyed).
In equity valuation, it is important to establish the link between EVA and Market Value
Added (MVA) : MVA equals the present value of all future EVA.
(1 ½ marks)
Total = 3 marks
Question 4 – Fixed Income Valuation and Analysis
The following factors, which should be of interest to an investor in bonds, are taken into
account by rating agencies in bond rating.
1. Creditworthiness
One of the biggest factors that affect bond rating is a company's credit risk. Credit risk
primarily refers to the company's ability to pay back its debts to its creditors. These
debts include principal and interest payments on loans, dividends and insurance
payments. Because a bond is a debt instrument, when investors purchase bonds, they
become creditors of the company from which they bought the bond. A company that is
less likely to default on its outstanding debt, meaning it demonstrates a high level of
creditworthiness, generally has a higher credit rating. As the creditworthiness of a
company decreases, the bond rating falls.
2. Future Performance
Like most investment instruments, bonds are forward looking. Credit rating agencies
conduct extensive research as to the plausible future performance of a bond. This
assessment affects a company's bond rating. Companies that have a history of good
financial standing and demonstrate that its current financial standing is unlikely to
change generally have high credit ratings. Companies that have experienced financial
instability or financial difficulties generally receive a lower credit rating.
3
3. Major Corporate Events
When a positive major corporate event occurs, such as the launch of an innovative
product, or a negative corporate event occurs, such as a corporate scandal, bond rating
agencies often place the bond rating of that company on review. Such events can affect
a bond rating. In the case of a negative corporate event, the bond rating is often
downgraded, because the company poses an increased risk of credit default and a drop
in creditworthiness. A positive corporate event may upgrade the company's bond rating.
(2 marks each for any 2 points)
Total = 4 marks
SECTION C: ESSAY TYPE/CALCULATIONS
Question 5 – Corporate Finance
5(a1)
Technohob Limited
Year
0
1
2
3
4
5
2.5
3
3.5
3
2.5
Cost savings
Depreciation tax
shield
1.500
1.575
1.654
1.736
1.823
1.050
1.050
1.050
1.050
1.050
Net cash flow
Discount factor @
12%
5.050
5.625
6.204
5.786
5.373
1
0.893
0.797
0.712
0.636
0.567
-15
4.509
4.484
4.416
3.677
3.049
Initial investment
-15
Incremental revenue
Present value
Net Present value
N5.135 million
(7 marks)
5(a2)
i.
NPV is a direct measure of the Naira contribution to the shareholders; hence it is
a good measure of wealth added to the firm by undertaking a project.
ii.
Apart from this, while IRR can give conflicting answers for mutually exclusive
projects, NPV does not.
iii.
Also in the case of “non-normal cash flow", there could be multiple IRR. This does
not happen with NPV.
(1 mark per point. Maximum 2 marks)
4
5( b1)
N
EBIT
5,000,000
Interest
(1,000,000)
4,000,000
Tax @ 30%
1,200,000
PAT
2,800,000
VE = D/KE
= 2,800,000/0.15
= N18,666,667
Price per share = N18,666,667/100,000 shares = N186.67
(Total = 5 marks)
5(b2)
WACC =
. Kd (1- t)
Vd
Vd + Ve
+
Ve
Vd + Ve
. Ke
Vd = 100,000 units X N100 = N10,000,000
Ve = 100,000 shares X N186.67 = N18,666,667
Kd = 10%
Ke = 15%
T = 30%
WACC = 10,000,000 X (0.1)(1-0.3)
28,666,667
+ 18,666,667 X (0.15)
28,666,667
= 0.0244 + 0.0977 = 0.1221 = 12.21%
(2 marks)
Alternatively , if share price per unit of N100 is assumed
Vd = 100,000 units X N100 = N10,000,000
Ve = 100,000 shares X N100 = N10,000,000
Kd = 10%
Ke = 15%
T = 30%
WACC = 10,000,000 X (0.1)(1-0.3)
20,000,000
+ 10,000,000 X (0.15)
20,000,000
= 0.035 + 0.075 = 0.11 = 11%
(2 marks)
5
Question 6 – Equity Valuation and Analysis
6(a)
Cash flow (in millions of Naira)
2012
2013
2014
105
135
175
Taxes
-31.5
-40.5
-52.5
NOPAT
73.5
94.5
122.5
20
25
30
93.5
119.5
152.5
CAPEX
-30
-25
-40
NWC
-50
-90
-110
13.5
4.5
2.5
EBIT
Depreciation
Gross cash flow
Free Cash Flow to
the Firm
(7 marks)
6(b)
Cost of capital for the firm is the cost of equity, since PolyExperts is all-equity financed.
First, we need to determine the cost unlevered beta.
Now,
Therefore,
KE
β unlevered = β levered / [ 1 + (1 – t) D/E]
β unlevered = 1.1/ [1 + (1 – 0.3)1/3]
= 0.89
(2 marks)
= Rf + (Rm –Rf) β
= 4% + 7%(0.89) = 10.28%
(2 marks)
6(c1)
+ 4.5
13.5
(1.1023)2
(1.1023)1
+
2.5
+
(1.1023)3
= 12.25 + 3.70 +1.87 +23.13
6(c2)
2.5 (1+0.02) X 1
(0.1023-0.02) (1.1023)3
= N 40.95 million
(3 marks)
Price per share = N40,950,000/100,000,000 shares
= 41 kobo/share
(2 marks)
Total = 16 marks
6
Question 7 – Fixed Income Valuation and Analysis
7(a)
Maturity
Zero-coupon bond yield
Zero-coupon bond price
Forward 1 year Interest rate
Duration
Modified duration
1 Year
2 Years
3 Years
2.500%
3.120%
C= 3.6205%
A = 0.9756
0.9404
0.8988
2.500%
D= 3.7438%
4.627%
1
2
3
B = 0.9756
1.9395
2.8952
Workings
A
Price = Redemption value
(1 + YTM)
= 100%
1.025
= 97.56%
= 0.9756
(1 ½ marks)
B
Dmodified =
D
(1 + YTM)
= 1
1.025
= 0.9756
(1 ½ marks)
C
Price = Redemption value
(1 + YTM3)3
0.8988 = 100%
(1 + YTM3)3
YTM3 = 3 - year spot rate
= 3.6205%
(2 marks)
D
(1+ S1)(1 + F) = (1 + S2)2
(1 + 0.0250)(1 + F) = (1+ 0.03120)2
F = (1+ 0.03120)2 - 1
(1 + 0.0250)
= 0.037438
= 3.7438%
(2 marks)
7
7(b1)
i.
The bond price-yield relationship is basically convex.
(1 ½ marks)
ii.
A bond's price and its yield are inversely related. That is, as yield rises, bond price falls.
(1 ½ marks)
(Total =3 marks)
7(b2)
Bond Price vs. Yield
4,000
Bond Price ($)
3,500
3,000
2,500
2,000
1,500
1,000
500
0%
5%
10%
15%
20%
25%
Yield to Maturity
From the graph above, approximately 1,250 (any figure around this should be given
credit.)
(2 marks)
7(b3)
(2 marks)
8
As illustrated above, callable bonds will exhibit negative convexity at certain price-yield
combinations.
Generally, as bond yields increase, bond prices are decreasing and thus interest rates
are increasing. A bond issuer would find it most optimal, or cost-effective, to call the
bond when prevailing interest rates have declined below the callable bond's interest
(coupon) rate.
For decreases in yields below *Y, the graph has negative convexity, as there is a higher
risk that the bond issuer will call the bond. As such, at yields below *Y, the price of a
callable bond won't rise as much as the price of a bond without embedded option.
(1 mark)
(Total= 3 marks)
7(b4)
The price of Bond X will probably fall because of the downgrade. Conversely, the yield to
maturity will rise in order to compensate for the reduction in price. The bond has more
risk than before, and the company must offer higher returns to entice investors.
(3 marks)
Total = 18 marks
9