CHARTERED INSTITUTE OF
STOCKBROKERS
ANSWERS
Examination Paper 1.2
Corporate Finance
Equity Valuation and Analysis
Fixed Income Valuation and Analysis
Professional Examination
March 2011
Level 1
1
SECTION A: MULTI CHOICE QUESTIONS
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
D
C
D
D
A
D
C
D
B
D
D
C
B
D
C
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
D
B
D
D
B
B
D
D
D
A
D
C
D
C
A
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
A
D
D
A
D
A
D
D
D
B
C
C
B
D
B
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
A
A
D
C
C
D
D
D
B
B
A
A
B
A
C
(60 marks)
SECTION B: SHORT ANSWER QUESTIONS
Question 2 - Corporate Finance
2(a)
Profitability index (PI), also known as Excess Present Value Index (EPVI), is the ratio of
payoff to investment of a proposed project. It is a useful tool for ranking projects in a
situation of capital rationing because it allows you to quantify the amount of value
created per unit of investment.
(1 marks)
2(b)
i. When the operating risk profile of a new project is different from that of existing
operations.
ii. Where there is project-specific financing of a project.
iii. Where the historic proportion of debt and equity in the capital structure changes.
(1 mark each for any two points)
= 2 marks
Total = 3 marks
2
Question 3 – Equity Valuation and Analysis
i.
ii.
iii.
iv.
v.
3(a)
To shore up its capital base.
To finance new viable projects internally.
Inadequate cash flow to pay dividend
When there a reduction in the amount of profit generated.
To reduce the gearing ratio.
(1 mark each for any two situations)
Total = 2 marks
3(b)
A defensive stock is a stock that tends to remain stable under difficult economic
conditions. Defensive stocks usually include food and utilities. These stocks hold up in
hard times because demand does not decrease as dramatically as it may in other
sectors. Defensive stocks tend to lag behind the rest of the market during economic
expansion because demand does not increase as dramatically in an upswing.
(2 marks)
Total = 4 marks
Question 4 – Fixed Income Valuation and Analysis
4(a)
HPY
=
96 – 93 + 5
93
x 100
= 8.60%
(1 mark)
4(b)
A Floating Rate Note (FRN) is a bond that has a variable coupon, equal to a money
market reference rate, like LIBOR, plus a spread. The spread is a rate that remains
constant.
(1 mark)
A FRN is attractive as a fixed income instrument because it carries little interest rate
risk. A FRN has duration close to zero, and its price shows very low sensitivity to
changes in market rates. When market rates rise, the expected coupons of the FRN
increase in line with the increase in forward rates, which means its price remains
constant.
(1 mark)
Total = 3 marks
3
SECTION C: COMPLUSORY QUESTIONS
Question 5 - Corporate Finance
5(a)
Using linear interpolation:
IRR =
L +
NL
NL - NH
X
(H -L)
IRR
Project
Ranking
A
12% +
12,250
15,830
X (20 – 12)% = 18.19%
1st
B
12% +
30,825
51,325
X (20 – 12)% = 16.81%
3rd
C
12% +
102,300
147,920
X (20 – 12)% = 17.53%
2nd
1 mark for each computation = 3 marks
Correct ranking
= 2 marks
5 marks
5(b)
5(b1) Sunk cost
Sunk costs are retrospective (past) costs that have already been incurred and cannot be
recovered. In using the DCF techniques, cash flows relating to sunk costs are
disregarded in project analysis as they are considered irrelevant in the decision-making
process.
(1 mark)
5(b2) Working capital
Working capital investments are relevant costs and are treated as follows:
i.
ii.
iii.
Initial investment in working capital is treated as a cash outflow at the start of the
project.
Any increase in working capital investment is treated as a relevant cash outflow in the
period in which it occurs.
At the end of the project all the working capital is released and treated as a cash
inflow.
(1 mark for any two points)
= 2 marks
4
5(b3) Inflation
Inflation results in a reduction of the real value of money. Fund providers therefore
would require additional return to compensate them for the reduction in the purchasing
power of their funds.
Generally in DCF analysis, to take account of inflation, nominal cash flows should be
discounted with the appropriate nominal rate of interest.
(2 marks)
Total = 10 marks
Question 6 - Equity Valuation and Analysis
6(a)
EPS (next year)
= N15
ROE
= 10%
= 12%
KE
g = ROE x retention ratio =10% x (1 -0.6) = 0.04
DO (1 + g) = N15 x 0.6 = N9
Share Price = DO (1 + g)
KE - g
= N9
=
0.12 - 0.04
(1 mark)
(1 mark)
N112.50
(1 marks)
I would buy the shares because they are significantly undervalued, currently trading at
N80 while having intrinsic value of N112.50 (a difference of N32.50).
(2 marks)
6(b)
Keeping all other factors constant, but changing only KE to 20%, we have:
Share Price = DO (1 + g)
KE - g
= N9
0.20 - 0.04
=
N56.25
(2 marks)
My decision would change from a buy to a sell decision. With required rate of return of
20%, the shares are now overvalued at N80 when they are actually worth N56.25.
(3 marks)
Total = 10 marks
Question 7 - Fixed Income Valuation and Analysis
7(a)
7(a1)
Putable bond.
A putable bond is a bond that gives the holder the right, but not the obligation, to
demand early repayment of the principal. The put option is usually exercisable on
specified dates.
It could be viewed as a combination of straight bond and embedded put option.
(1 mark)
5
7(a2)
Interest rate risk
This is the risk borne by an fixed income securities, such as a bond, due to variability of
interest rates. In general, as rates rise, the price of a fixed rate bond will fall, and vice
versa. Interest rate risk is commonly measured by the bond's duration.
(1 mark)
7(a3)
Immunization strategy
Interest rate immunization is a strategy that ensures that a change in interest rates will
not affect the value of a portfolio. It can be accomplished by several methods, including
cash flow matching, and duration matching. It can also be accomplished by trading in
bond forwards, futures, or options.
(1 mark)
7(a4) Sinking fund provision
Sinking fund is a special fund established by a government agency or company for the
purpose of repaying a bond issue.
From the investor's point of view, a sinking fund adds safety to a bond issue. With it, the
issuing company is less likely to default on the repayment of the remaining principal
upon maturity.
(1 mark)
7(b)
Bond price =
=
N1,000
(1 + 0.05)5
N783.53
The maximum price I would pay for the bond is N783.53.
(1 mark)
Explanation
This is a zero-coupon bond, and the amount computed above represents the present
value of the future cash flow derivable from the bond. It does not make economic sense
to pay more for a security than the present value of its future benefits.
(1 mark)
7(c)
Computation of straight bond value
= N50
(1 + 0.07)
= N46.73
= N917.99
+
+
N50
+
N50
+
(1 + 0.07)3
(1 + 0.07)2
N43.67
+
N40.81
+
N50
+
N1, 050
(1 + 0.07)4
(1 + 0.07)5
N38.14
+
(2½ marks)
N748.64
(1½ marks)
= 4 marks
Note
The straight value of a convertible bond is the present value of all future cash flows
discounted at the yield to maturity of comparable bonds without the conversion feature;
which is 7% in this case.
Total = 10 marks
6