PAPER 2.2
QUESTIONS AND SOLUTIONS
SEPTEMBER 2014 DIET
Page 1 of 12
Question 2 – Corporate Finance
Small Limited is a very attractive company at the growth stage, generating enormous cash
flows. Unfortunately, it has become a target for acquisition by stronger, well established
companies in the industry.
Briefly explain the following strategies it could employ to ward off interested acquirers:
Question 2(a)
Poison Pill.
(11/2 marks)
Solution 2(a)
Small limited decides to design a strategy that triggers a new prohibitive cost that must be
paid by the acquirer after takeover. For example if Small limited issues right to all existing
shareholders (with the exception of the hostile acquirer) to acquire its stock at prices
significantly below market price in the event of a cash tender offer or the acquisition by an
outsider of a specified percentage of its shares.
Question 2(b)
Crown Jewel.
(11/2 marks)
Solution 2(b)
Small limited decides to sell its prized and most covered assets so as to reduce its
attractiveness to the potential acquirer.
Page 2 of 12
Question 3 – Equity Valuation and Analysis
The price/earnings ratio, or multiplier approach, may be used for stock valuation. Explain
this process and describe the variant of the "multiplier" that would give the best result.
(3 marks)
Solution 3
The P/E ratio is sometimes referred to as the multiple.
In using the P/E ratio approach to value stock the following approach is taken:
i) The earnings per share of the company to be valued is determined.
ii) The P/E ratio of a company considered similar to it (or it’s peers) is determined. Lets
assume similar companies have a P/E ratio of 10
iii) The company’s value is determined by multiplying the EPS by the P/E ratio
i.e. P/E X EPS
The price earnings ratio used for stock valuation should be the predicted price/earnings
ratio. That is, the ratio of the current price of the stock divided by the expected earnings
per share for the coming year. Thus, the ratio is the stock price as a percentage of
expected earnings. All valuation models should be based on what the investor is expecting
to receive in the coming period, not upon what past investors have received. Such a
forecasted price/earnings ratio is published in Value Line.
Page 3 of 12
Question 4 – Fixed Income Valuation and Analysis
Determine whether the value of a callable convertible bond will increase, decrease, or
remain unchanged in response to each of the following changes, and justify each of your
responses with one reason:
Question 4(a)
An increase in stock price volatility.
(2 marks)
Solution 4(a)
The value of callable convertible bond = value of the straight bond + value of conversion
option - value of the call option on the bond.
An increase in stock price volatility will increase the value of the bond because the
conversion option on the stock becomes more valuable.
Question 4(b)
An increase in interest rate volatility.
(2 marks)
Solution 4(b)
The value of callable convertible bond = value of the straight bond + value of conversion
option - value of the call option on the bond.
An increase in interest rate volatility will decrease the value of the bond because the
chance of the bond being called increases, causing the value of the call option on the bond
to become more valuable.
Page 4 of 12
Question 5 – Corporate Finance
XYZ Limited, a manufacturing company is diversifying its operations into gold mining. The
company has just acquired a mining license for a new project that has been estimated will
last for 15 years.
Initial projections suggest that the project will generate Free Cash Flow (FCF) of N65
million in the first year, rising by 100% per year in each of the next two years, and then by
15% in each of the two years after that. The FCF are then expected to stabilize at the yearfive level for the remaining 10 years. The cost of the project, payable at the start, is
expected to be N1,500 million, comprising machinery, working capital and the mining
rights fee payable to the Nigerian government. Only N280 million of these costs is expected
to be recoverable at the end of the project’s 15-year life.
Question 5(a)
Using the company’s existing WACC of 18%, advise the directors whether the project
should be undertaken or not.
(7 marks)
Solution 5(a)
Year
0
1
2
3
4
5 - 15
15
Cash Flow
(1,500)
65
130
260
299
344
280
D/F @ 18%
1
0.847
0.718
0.609
0.516
2.402 (wk 1)
0.0835 (wk 2)
NPV
PV
(1,500)
55
93
158
154
826
23
-191
(3 marks)
(2 marks)
(1 mark)
Working 1
PV of Annuity factor for years 5 – 15 equals PV of Annuity factor years 1 to 15 less PV of
Annuity factor years 5 to 15.
(1 mark)
1 – (1 + r)-n
r
-
Formulae for PV of Annuity factor
= 1 – (1 + 0.18)-15
0.18
=
5.092
= 1 – (1 + 0.18)-4
0.18
=
(2.690) (factor for years 1 to 4)
2.402 (factor for years 5 to 15)
=
0.0835
(factor for years 1 to 15)
Working 2
1/(1.18)15
Advice
The project should not be undertaken as it gives a negative NPV.
(1 mark)
Page 5 of 12
Question 5(b)
The project consultant has raised some concerns about the use of XYZ Limited’s current
WACC in appraising the mining project as he believes the company’s business risk will
change as a result of undertaking the mining project.
Discuss the merit or otherwise of his concerns, outlining the steps to be taken if a project
specific cost of capital is more appropriate.
(5 marks)
Solution 5(b)
Indeed it is likely that the company’s overall business risk will change as a result of
undertaking the mining project because the company’s current business is manufacturing
and the two ventures most likely will have different business risks.
If this is true, then a project specific cost of capital will be more appropriate.
Steps:
a. Identify a similar business but which is into mining.
b. Determine the beta factor of this business (this will likely be the equity beta or geared
beta).
c. Ungear the equity beta to get the asset/ungeared beta.
d. Re-gear the asset beta determined above taking cognisance of the specific financial
risk of XYZ limited.
e. Using the CAPM, determine the new cost of equity of XYZ limited and then compute
WACC as appropriate.
(3 marks)
Question 5(c)
Briefly discuss the treatment and impact of the following items on the project.
(No calculations required).
Question 5(c1)
The sum of N120 million spent in assessing the technical viability.
(2 marks)
Solution 5(c1)
This is sunk cost and it is irrelevant in appraising the project. It therefore has no
impact.
(2 marks)
Question 5(c2)
A reduction in project costs by N500 million through a subsidy provided by
the
Nigerian government.
(2 marks)
Solution 5(c2)
This will reduce the initial project cost and increase the NPV as follows:
Current NPV =
(N191 million)
Reduction in project cost
N500 million
Adjusted NPV
N309 million
The project should be accepted under this condition as it now turns a positive NPV.
Page 6 of 12
(2 marks)
Question 6 –Equity Valuation and Analysis
The shares of New Energy Plc are quoted on the Nigerian Stock Exchange, and are
currently trading at N80. You would like to consider investing in the shares of the company,
but intend to carry out some research before taking the final decision.
The research department of your stockbroking firm was able to provide you with some
relevant information:
Projected EPS (for next year)
Dividend payout ratio
Return on equity
Required rate of return
-
N15
60%
10%
12%
Question 6(a)
What is your opinion on the intrinsic value of the shares, using the dividend growth model?
Based on this, what action would you take?
(5 marks)
Solution 6(a)
VE = D0 (1 + g)
KE - g
=
D1
KE - g
D1 = EPS X Payout ratio = N15 X 60% = N9
g = ROE X retention ratio = 10% X (1-0.6)
= 10% X 0.4 = 4%
KE = 12%
VE =
N9
0.12 -0.04
= N112-50
Comment
The shares of New Energy Plc are undervalued by the market to the tune of N32.50
(i.e 112.50 – 80), as the intrinsic value is N112.50 per share.
Based on this I would buy the shares.
Question 6(b)
You discovered that the correct estimate of the required rate of return was actually 20%.
Will this change your decision in 6(a) above?
(3 marks)
Solution 6(b)
Now, only KE will charge to 0.2 from 0.12
VE =
D
kE–g
=
N9
0.2 – 0.04
=
N 56.25
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Intrinsic value has now changed to N56.25. Based on this I will sell the shares as they
are overvalued – that is, going for N80 in the market when they are really worth
N56.25.
Question 6(c)
New Energy Plc is in discussions with the directors of a competitor, Blooming Limited with a
view to acquiring the company in pursuit of their expansion plans, through a cash offer. In
analyzing the proposed combination, you have estimated that the combined entity will
generate Free Cash Flow to the Firm (FCFF) to the tune of N850 million in the first year,
after taking cognizance of all synergy benefits. This is expected to grow at a rate of 2% p.a
forever. The combined entity is expected to have 60 million ordinary shares in issue, a
WACC of 15% and debt capital of N725 million (market value).
Question 6(c1)
Estimate the per share value of the combined entity using the Free Cash Flow valuation
approach, and advice the directors whether to proceed with the acquisition plans or not.
(5 marks)
Solution 6(c1)
EV = FCFF (1 + g)
WACC – g
= 850 (1 + 0.02)
0.15 – 0.02
= N867m
0.13
= N6,669m in one year’s time
Discounting to present value = 6669
1.15
Enterprise value = N5,799
Now:-
Ev = VE + VD
5,799 = VE + 725
VE = 5,799 – 725 = 5074
Per share value = N5,074m
60m shares
=
N84.57/share
Advise
The company should go ahead with the acquisition since the post-acquisition share value
@N84.57/share is higher than the pre-acquisition value @N80 per share.
Page 8 of 12
Question 6(c2)
Briefly discuss some of the assumptions made in your calculations and analysis above.
(3 marks)
Solution 6(c2)
i) Generally, all the key estimates are assumed to be realistic e.g. FCFF of N850
million. If this ends up being wrong, then the valuation will also be wrong.
ii) The assumption that free cash flow will grow at the rate of 2% per annum forever
may be unrealistic.
iii) The WACC of 15% used as discount rate assumes this will be the cost of capital
forever. In real life, this is not true as WACC is not constant.
Page 9 of 12
Question 7 – Fixed Income Valuation and Analysis
Question 7(a)
The liquidity premium hypothesis holds that issuers of bonds prefer to issue long-term
bonds. How would this preference contribute to a positive liquidity premium?
(2 marks)
Solution 7(a)
If issuers prefer to issue long-term bonds, they will be willing to accept higher expected
interest costs on long bonds over short bonds. This willingness combines with investors’
demands for higher rates on long-term bonds to reinforce the tendency toward a positive
liquidity premium.
Question 7(b)
Suppose that a one-year zero-coupon bond with face value ₦100 currently sells at ₦95.34,
while a two-year zero sells at ₦84.99. You are considering the purchase of a two-yearmaturity bond making annual coupon payments. The face value of the bond is N100, and
the coupon rate is 12% per year.
Question 7(b1)
What is the yield to maturity of the two-year zero, and the two-year coupon bond?
(5 marks)
Solution 7(b1)
The one-year bond has a yield to maturity of 6%:
94.34 =
100
(1 + y)

y = 0.06 = 6%
The yield on the two-year zero is 8.472%:
84.99 =
100
(1 + y)2
 y = 0.08472 = 8.472%
12
+
(1 .04888)
The price (P) of the coupon bond is:
112
(1.08472)2
=
11.441 + 95.118 = ₦106.56
Therefore, its yield to maturity is given by the value of k in the following:
12
1+k
106.51 =
+
112
(1+ k)2
Solve for K (i.e IRR) using a financial calculator or trial and error method
k
= 8.33%
Page 10 of 12
This is IRR. Use financial calculator or trail & error method to compute it.
Trial & Error Methods
0
(106.5)
D/F @ 5%
1
(106.5)
D/F @ 10%
1
(106.5)
1
12
0.952
11.424
0.909
10.908
2
112
101.584
6.508
0.826
92.512
3.08
0.907
IRR = 5% + (10% - 5%) X 6.508
9.588
= 8.39%
Question 7(b2)
What is the forward rate for the second year?
(3 marks)
Solution 7(b2)
Forward rate for the second year is given by F 1,2.
F1,2
(1+i2t)2
= 1+it
F1,2 =
-1
(1.08472)2 - 1
1.04888
= 12.178 = 12%
Question 7(b3)
If the expectations hypothesis is accepted, what are (1) the expected price of the
coupon bond at the end of the first year and (2) the expected holding-period return
on the coupon bond over the first year?
(4 marks)
Solution 7(b3)
At the end of the first year, the two-year coupon bond will have one year to maturity.
Expected price =
112
1.12178
= 99.8413
Expected holding period return
=
12 + 99.8413
106.51
-
1
= 4.886% (approx)
Page 11 of 12
4.96%
This is (and must be) the same as the return on one-year zero.
Question 7(b4)
Will the expected rate of return be higher or lower if you accept the liquidity
preference hypothesis?
(2 marks)
Solution 7(b4)
Liquidity theory predicts that longer maturities should be compensated for a term
premium. The return should be higher because of the additional liquidity premium
required.
Using mathematical reasoning:
If there is a liquidity premium, then:
E(r2)
< F1,2
112 > 100.90
E(Price)
=
E (HPR)
> 6% 1 + E(r2)
Note:
E(r2)
E(Price)
E(HPR)
= expected short-term interest rate in year 2
= expected price
= expected holding period return.
Page 12 of 12