CHARTERED INSTITUTE OF
STOCKBROKERS
ANSWERS
Examination Paper 2.2
Corporate Finance
Equity Valuation and Analysis
Fixed Income Valuation and Analysis
Professional Examination
March 2011
Level 2
1
SECTION A: MULTI CHOICE QUESTIONS
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
B
B
B
B
A
D
B
B
C
D
D
D
C
C
D
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
C
C
D
B
A
A
B
D
D
C
D
C
B
B
D
31
32
33
34
35
36
37
38
39
40
C
B
B
C
D
A
C
A
B
A
(40 marks)
SECTION B: SHORT ANSWER QUESTIONS
Question 2 – Corporate Finance
i.
Using CAPM , the approach involves determining relevant variables in the CAPM
model applicable to the project under consideration as below:
KE = Rf + (Rm – Rf) β
Where,
Rf = risk-free rate in the economy.
Rm = market return.
β = equity (levered) beta for the project.
(2 marks)
ii.
If the appropriate levered beta is available, then you can make use of it directly in
the formulae above.
iii.
If you do not have the levered beta, but have the appropriate unlevered beta,
then you have to re-gear the unlevered beta to derive the levered beta (which
reflects the gearing level of the project) using the relationship below:
(1 mark)
Total = 3 marks
2
Question 3 – Equity Valuation and Analysis
3(a)
Market Value Added (MVA) is the difference between the current market value of a firm
and the capital contributed by investors. If MVA is positive, the firm has added value. If
it is negative, the firm has destroyed value. A high MVA indicates the company has
created substantial wealth for the shareholders.
It is calculated as:
MVA = Company’s Market Value – Invested Capital.
(2 marks)
3(b)
i.
ii.
iii.
iv.
Appropriate pricing – Setting an offering price that is low enough to stimulate
interest in the stock, but high enough to raise an adequate amount of capital for
the company.
Good timing – when the investment climate is attractive.
Firm underwriting arrangement- which ensures that the underwriter guarantees
the sale of the issued stock at the agreed-upon price.
Effective marketing efforts to create awareness about the offering an sell the
prospects of the offering.
(1/2 mark each for any two points)
= 1 mark
Total = 3 marks
Question 4 – Fixed Income Valuation and Analysis
4(a)
Mortgage pass-through security (or simply pass-through) is the simplest form of
mortgage-backed security whereby all principal and interest payments from the pool of
mortgages are passed directly to investors each month.
(2 marks)
4(b)
Cash-flow matching strategy involves matching estimated liabilities with investments
that will provide enough return to balance a portfolio. Cash flow matching is often used
in pension fund management, since a stream of future liabilities has to be met with
adequate cash flows in order to keep the pension funded.
(2 marks)
Total = 4 marks
3
SECTION C: ESSAY TYPE/CALCULATIONS
5(a)
Debt = 1,000 x 100 = N100,000
Equity = 2,000 x N25 = N500,000
Debt/equity ratio = N100,000/ N500,000 = 20%
(2 marks)
5(b)
5(b1)
In a world without taxes
WACC =
. Kd
Vd
Vd + Ve
+
Ve
. Ke
Vd + Ve
First determine cost of debt (Kd) and cost of equity (Ke)
Cost of debt
= 10% (since par value of debt equals market value of debt)
(1 mark)
Cost of equity, using dividend growth model
Po = DO (1 + g)
Ke - g
Ke = DO (1 + g) + g
Po
= N50/N250 + 0.05
WACC =
= 0.2 +0.05 = 0.25 = 25%
X 10% +
100,000
100,000+500,000
= 0.1667 X 0.1 + 0.8333 X 0.25
= 0.01667 + 0.208325
= 0.224995
= 22.50%
(1 mark)
500,000
X 25%
100,000 + 500,000
(2 marks)
4
5(b2)
In a world with taxes, we need to take account of the tax rate of 30% which would impact
the cost of debt only.
WACC =
=
=
=
=
X 10% (1- 0.3)
100,000
100,000 + 500,000
+
500,000
X 25%
100,000 + 500,000
0.1667 X 0.1 (0.7) + 0.8333 X 0.25
0.011667 + 0.208325
0.21999
22 %
(2 marks)
5(c)
In a world without taxes, increase in debt/equity ratio would have no impact on both WACC and
firm value. However, in a world with taxes, the higher the debt/equity ratio, the lower the WACC,
and the higher the firm value.
(3 marks)
5(d)
From the CAPM formulae, beta could be derived as follows:
Ke = Rf + (Rm – Rf) β
β = (Ke - Rf ) / (Rm – Rf) = (25% - 10%) /(18% - 10%) =15/8 = 1.875
(2 marks)
If the company were to be entirely equity financed, then its beta would be equivalent to
an ungeared beta.
Therefore we have to ungear the above equity beta of 1.875 to derive the asset beta
using the formulae below:
=
/
= 1.875/ 1 + (1 - 0.3)(0.2) = 1.875/1.14 =
1.64
(3 marks)
Total = 16 marks
5
Question 6 – Equity Valuation and Analysis
6(a)
WACC =
. Kd (1- t)
Vd
Vd + Ve
+
Ve
Vd + Ve
. Ke
Debt/ Total capital= 30%
Therefore Equity/ Total capital = 70%
(1 mark)
Cost of debt (Kd) = 7%
Cost of equity (Ke), using CAPM
Ke = Rf + (Rm – Rf) β
= 3% + 6% x 0.92
= 35 + 5.52 = 8.52%
WACC =
X 7% (1- 0.4) +
215
716.67
= 0.012599941
= 0.07224
(1 mark)
501.67 X 8.52%
716.67
+ 0.059640
(2 marks)
WACC = 7.22%
6(b) Forecast future periods free cash flow.
Now (year 0) = N24 million
Year 1 = N24 (1+ 0.21)
= N29.04 million
(1 mark)
Year 2 = N24 (1 + 0.21)2 = N35.14 million
(1 mark)
Year 3 = N24 (1 +0.21)2 (1 +0.17) = N41.11 million
(1 mark)
Terminal value at the end of year 3
= FCF3 (1+g)/ (WACC – g)
= N41.11 (1+0.03)
0.0722 - 0.03
= 42.3433 =
0.0422
N1,003.40 million
(1 mark)
6
6(c)
PV of cash flows
=
+
35.14
29.04
(1.0722)2
(1.0722)1
= N27.08
+
N30.57
+
+
41.11
(1.0722)3
N33.35
+
1,003.40
(1.0722)3
(2 marks)
+ N814.04
(2 marks)
= N 905.04 million
Alternatively, if the candidate used a WACC of 10% as allowed in the question:
=
29.04
(1.10)1
= N26.40
+
35.14
(1.10)2
+
N29.04
+
+
41.11
(1.10)3
N31.13
+
+
1,003.40
(1.10)3
(2 marks)
N753.87
(2 marks)
= N 840.44 million
6(d)
Value of equity = Total firm value- value of debt
= 905.04 million – 215 million
=N690.04 million
(2 marks)
Value per share = Equity value/ Number of ordinary shares outstanding
= N690.04 million /5 million
(2 marks)
= N138
Total = 16 marks
Question 7 – Fixed Income Valuation and Analysis
7(a)
Price of bond X
= 8 /(1 +0.0765)1 + 108/1 +0.0785)2
= 7.43
+ 92.85
= N100.28
(3 marks)
7
7(b)
=
- 2.76
X 0.2%
(1 +0.08027)
= 0.5238
X 102.51
= 52.38% change in price
(3 marks)
There is a weakness in the use of duration to estimate changes in bond prices when yield
changes. The approach is simply an approximation, and would be accurate only with
very small changes in yield. Further, the duration concept assumes parallel shift in the
yield curve. This does not usually hold true in practice.
(2 marks)
7(c)
7(c1)
Bond Z is a zero-coupon bond, as it does not pay interest during the life of the bond. Its
single cash flow occurs at redemption.
(2 marks)
7(c2)
Bond Z is protected from re-investment risk arising from interest rate volatility, which
may be detrimental to the re-investment of cash flows from interest on coupon bonds. A
zero-coupon bond could therefore be useful in protecting a bond portfolio form the risk
of loss arising from this factor.
A zero-coupon bond could be used for cash-flow matching, a strategy that ensures that
future liabilities are met with adequate cash flows irrespective changes in market
interest rates.
Either of the above points
(3 marks)
7(d)
7(d1) Credit spread?
Credit spread is the yield differential between Treasury securities and non-Treasury
securities that are identical in all respects except for quality rating. For instance, if the
yield on a 5-year government bond is 5%, and that on 5-year single A-rated corporate
bonds is 6%, then credit spread is 1% (6% -5%).
Credit spread reflects the credit risk being faced by investors. A company must offer a
higher return on their bonds than government securities because they have a higher
credit risk.
(2 marks)
8
7(d2)
Credit spread widens when the economy faces a downturn because default risk on
corporate bonds increases at this time. Most investors therefore would take a ‘flight to
safety’ by buying government bonds which are less risky. This means companies would
have to increase the yield on their bonds in order to attract investors and compensate
them for the additional risk undertaken.
The reverse applies when the economy is in a boom. Companies are generally buoyant
and liquid, therefore credit risk is low. The spread between government bonds and
corporate bonds shrinks under this condition.
(3 marks)
Total = 18 marks
9