CIS September 2013 Exam Diet
Examination Paper 2.2:
Corporate Finance
Equity Valuation and Analysis
Fixed Income Valuation and Analysis
Level 2
SECTION A: MULTIPLE CHOICE QUESTIONS
Corporate Finance (1 – 13)
1.
You are given the following information from the financial statements of Real
flow Limited:
Profit before interest and tax
Depreciation
Taxes
Increase in new investments
Increase in working capital
N750,000
N125,000
30%
N250,000
N150,000
What is the free cash flow to equity?
A.
N150,000
B.
N250,000
C.
N550,000
D.
N650,000
2.
Stock A has an expected return of 10% per year and stock B has an expected
return of 20%. If 55% of the funds are invested in stock B, what is the expected
return on the portfolio of stock A and stock B?
A. 10%
B. 20%
C. 15.5%
D. None of the above.
3.
A firm has N100 million in current liabilities, N200 million in total long-term
liabilities and N300 million in stockholders' equity, total assets of N600 million.
What is the debt ratio for the firm?
A. 40%
B. 20%
C. 50%
D. None of the above.
4.
Firm A has a value of N100 million, and B has a value of N70 million. Merging
the two would allow a cost savings with a present value of N20 million. Firm A
purchase B for N75 million. What is the gain from this merger?
A. N30 million.
B. N20 million.
C. N15 million.
D. N10 million.
5.
What are some of the possible consequences of financial distress?
A. Debt holders, who face the prospect of getting only part of their money
back, are likely to want the company to take additional risks.
B. Equity investors would like the company to cut its dividend payment to
conserve cash.
C. Equity investors would like the firm to shift toward riskier line of business.
D. Equity investors would like the firm to set up with creditors as fast as
possible.
6.
As a defensive maneuver, a firm issues bonds that make it prohibitively costly
for an acquirer in the event of an unfriendly takeover. These tactics are
examples of _____________
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A.
B.
C.
D.
7.
Greenmail.
A poison put.
Crown jewels.
White knight.
Consider the following statements:
I.
A beta factor measures the relationship between market returns and the
returns of an individual security.
II. A share that has a beta of 1·0 will have an expected return that moves in
step with market return.
Which one of the following combinations (true/false) concerning the above
statements is correct?
A.
B.
C.
D.
Statement I
True
True
False
False
Statement II
True
False
True
False
8.
When comparing geared versus ungeared capital structure, gearing works to
increase EPS for high levels of generated income because ___________
A. Interest payments on the debt vary with EBIT levels.
B. Interest payments on the debt stay fixed, leaving less income to be
distributed over less shares.
C. Interest payments on the debt stay fixed, leaving more income to be
distributed over less shares.
D. Interest payments on the debt stay fixed, leaving less income to be
distributed over more share.
9.
Which of the following comprises features from both equity and debt securities?
A. Debentures.
B. Mortgage-backed securities.
C. Convertible notes.
D. Currency swaps.
10. If the weighting of equity in total capital is 1/3, that of debt is 2/3, the return on
equity is 15% that of debt is 10% and the corporate tax rate is 32%. What is
the weighted average cost of capital (WACC)?
A. 10.533%
B. 7.533%
C. 9.533%
D. 11.350%
11. Which of the following statements is false with respect to the similarities and
differences that exist between warrants and convertible bonds?
A. Convertible bonds are typically issued in public markets, whereas warrants
are more common among private placements.
B. Neither the exercise of a warrant nor the conversion of a convertible bond
should have any direct impact on the assets of the firm.
C. Warrants may be sold as stand alone securities, whereas the call option
embedded in a convertible bond may not.
D. From the investor's point of view, the conversion of warrants or convertible
bonds into shares may result in different tax consequences.
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12. ABC Limited can reinvest net income to earn 22% per year. What will be Zuma’s
long term dividend growth rate if the company constantly pays out 45%
earnings as dividends?
A. 12.1%
B. 13.5%
C. 14.3%
D. 62.9%
13. Which of the following factors would not tend to be associated with company
having a low dividend payout ratio?
A. High floatation costs on new equity issues.
B. High tax rates on dividends.
C. Low growth prospects.
D. None of the above.
Equity Valuation and Analysis (14 – 26)
14. The economy has just entered a state of recovery, and you would like to
purchase a stock that would generate high returns in the coming months.
Buying which of the following categories of stocks would most likely help you to
achieve your objective?
A. Cyclical stocks.
B. Counter-cyclical stock.
C. Defensive stocks.
D. Value stocks.
15. The DRD Company has a debt equity ratio of 1.5. The cost of debt is 11% and
the unlevered equity is 14%. What is the weighted average cost of capital for
the firm if the tax rate is 33%?
A. 7.37%
B. 25.1%
C. 11.22%
D. None of the above.
16. The current dividend yield on C. M. Limited ordinary shares is 2.5 percent. The
company just paid a N1.48 annual dividend and announced plans to pay N1.54
next year. The dividend growth rate is expected to remain constant at the
current level. What is the required rate of return on this stock?
A. 6.55 percent.
B. 6.82 percent.
C. 7.08 percent.
D. 7.39 percent.
17. The accounts of XYZ Limited for the year ended 31 December 2012 show a
profit after tax of N2,900,000. The managing director wishes to assess
performance using Economic Value Added. The finance director has provided the
following data:
Value of assets employed:
Cost of capital:
Net book value N4,759,600
Economic value N5,200,000
15% per annum.
What is the EVA for the year ended 31 December 2012?
A. N203,024
B. N583,580
C. N2,120,000
D. N2,186,060
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18. Hardy Lumber has a capital structure which includes bonds, preferred stock and
common stock. Which of the following rights have most likely been granted to
the preferred shareholders?
I.
II.
III.
IV.
Right
Right
Right
Right
to
to
to
to
share in company profits prior to other shareholders.
elect the corporate Directors.
vote on proposed mergers.
all residual income after the common dividends have been paid.
A.
B.
C.
D.
I only.
I and II only.
I and IV only.
II, III and IV only.
19. Although exit and entry barriers are conceptually different, their joint level is an
important aspect of the analysis of an industry. Which of the following is most
likely true, if entry barriers are low and exit barriers are high in the industry?
A. Returns are high and stable.
B. Returns are low and risky.
C. Returns are high and risky.
D. Returns may vary depending on industry selected.
20. J & J Foods wants to issue a 7 percent preferred stock that has a stated
liquidating value of N100 a share. The company has determined that stocks with
similar characteristics provide a 12.8 percent rate of return. What would be the
offer price?
A. N37.26
B. N41.38
C. N48.20
D. N54.69
21. The intrinsic value of stocks are the estimates of EPS and P/E multiple. Which of
the following would you consider the best indicator of an undervalued firm?
A. A firm with a P/E ratio lower than the average P/E ratio for the firm’s peer
group.
B. A firm with a lower P/E ratio, a lower expected growth rate and lower risk
than its peer group.
C. A firm with a lower P/E ratio, a higher expected growth rate and higher risk
than its peer group.
D. A firm with a lower P/E ratio, a higher expected growth rate and lower risk
than its peer group.
22. The security market indices are useful for different purposes. Which of the
following statements is/are not true?
A. Security market indices are the basic tools to help and analyze the
movements of prices of various stocks listed in stock exchanges.
B. Indices can be calculated company wise to know their trend pattern and also
for comparative purposes across the industries and with the market indices.
C. The investors can make their investment decisions accordingly by estimating
the realized rate of return on the index between two dates.
D. Funds can be allocated more rationally between stocks with knowledge of the
relationship of prices of individual stocks with the movements in the market
indices.
23. Business firms in their pursuit of growth, engage in a broad range of
restructuring activities. Divestiture is one among them. The term ‘divestiture’
involves which of the following activities?
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I. Distribution of shares to the existing shareholders of the parent company.
II. Sale of a portion of the firm through an equity offering to outsiders.
III. Sale of a portion of the firm to an outside third party in consideration of cash
or equivalent.
A.
B.
C.
D.
I only.
II only.
III only.
I and II only.
24. Reliable Investment Company is investing N100 in a project that is being
depreciated straight-line to zero over a two-year life with no salvage value. The
project will generate economic profit of N23 and N29 in the first and second
years respectively.
The company's weighted average cost of capital and required rate of return for
the project are both 12% and its tax rate is 30%. What is the market value
added (MVA) for the company?
A. 38.87
B. 39.92
C. 43.65
D. 37.78
25. Which of the following is a benefit of securitization of asset-backed securities to
a firm? Securitization ____________
A. Converts receivables into cash.
B. Reduces the business risk of the firm.
C. Removes assets from the firm’s balance sheet, thus reducing the firm’s
exposure to interest rate risk and credit risk.
D. Provides a lower cost form of obtaining funds.
26. PQR Plc is an oil company with debt of N4,000,000 and equity of N10,000,000.
Shares in an equivalent all-equity financed company have a beta of 1.41.
Assuming the applicable company income tax rate is 30%, what is the geared
beta of PQR Plc shares?
A. 1.24
B. 1.41
C. 1.80
D. 2.68
Fixed Income Valuation and Analysis (27 – 40)
27. Which of the following statements is incorrect regarding credit default swaps?
A. A CDS is in effect an insurance policy on the default risk of a corporate
bond.
B. CDS were designed to allow lenders to buy protection against losses on
sizable loans.
C. CDS are designed to transfer the credit exposure of variable income
products between parties.
D. The swap buyer pays an annual premium to the swap seller in exchange,
receives a payoff if a credit instrument goes into default.
28. The yield curve indicates that the one, two and three-year maturity, defaultfree, zero-coupon bonds have yields-to-maturity of 5%, 6% and 8%
respectively. What are the implied one-year forward rates?
A. 2.0%, 6.0%
B. 6.0%, 2.0%
C. 7.0%, 12.11%
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D. 12.1%, 6%
29. Which of the following bond prices, all with par value of N100, is most sensitive
to market rate change?
A. 5-year, 5% coupon rate, yield = 5.5%
B. 3-year, 8% coupon rate, yield = 5.6%
C. 7.5-year, 4.5% coupon rate, yield = 5.5%
D. 10-year, 4.5% coupon rate, yield = 5.5%
30. You purchased an annual interest coupon bond one year ago that had 6 years
remaining to maturity at that time. The coupon interest rate was 10% and the
par value was N1,000. At the time you purchased the bond, the yield to
maturity was 8%.
If you sold the bond after receiving the first interest payment and the yield to
maturity continued to be 8%, your annual total rate of return on holding the
bond for that year would have been ________
A. 7.00%
B. 7.82%
C. 8.00%
D. 11.95
31. Which of the following loans is typically not secured?
A. Collateral trust bond.
B. Mortgage bond.
C. Floating rate note.
D. Equipment trust certificate.
32. Which of the following is/are false in relation to term structure of interest rates?
I. Yield curve cannot have a negative slope.
II. Yield spreads between high and low grade corporate bonds tend to widen
during a boom period in the economy.
III. Riding the yield curve is a strategy that requires purchase of long term bonds
in anticipation of capital gains as yields fall with the declining maturity of the
bonds.
A.
B.
C.
D.
II only.
I and II only.
I and III only.
II and III only.
33. Which of the following theories advocates that the investors are not indifferent
to risk and they charge higher rates than the expected future rates, if the
maturity of the instrument increases?
A. Liquidity preference theory.
B. Pure expectations theory.
C. Loanable funds theory.
D. Liquidity premium theory.
34. Which of the following statements is false regarding bond immunization?
A. This is the strategy of matching the bond‘s duration with the time horizon of
the investor.
B. Investor can protect themselves from the interest rate risk through bond
immunization.
C. Immunization will provide a compound rate of return over the period
immunized that equals the bond‘s YTM, irrespective of changes in market
rates.
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D. Immunization means that investor has to sell a part or the whole of the
portfolio and buy other securities so that the duration of the new portfolio
coincides with the investor investment horizon.
35. A bond has following features:
Current price = N980.00
Modified duration = 6.76 years.
What is the new price of the bond if the prevailing interest rate changes from
12% to 11%?
A. N1,040.62
B. N1,100.00
C. N1,140.62
D. N1,240.62
36. A convertible bond has a par value of N1,000 and a current market value of
N850. The current price of the issuing firm's stock is N27 and the conversion
ratio is 30 shares. The bond's conversion premium is _________
A. N40
B. N150
C. N190
D. N200
37. Which of the following types of investments experience the least interest rate
risk?
A. Zero coupon bonds.
B. Long term Government bonds.
C. Long term corporate bonds.
D. Short term treasury bills.
38. Which of the following causes a lower required return on a bond?
A. Dividend restrictions are placed on the company.
B. The bond has no collateral.
C. The bond is subordinated to other debt.
D. (A) and (C) above.
39. Lara wants to buy a bond and hold it until it matures. Which of the following
must occur if Lara is to realize a holding period return equal to the bond’s yield
to maturity?
A. She must reinvest all coupons to earn the yield to maturity.
B. The issuer must not call the bond away early.
C. The issuer must make all payments in full and on schedule.
D. All of the above.
40. Which of the following observations is relevant to a mortgage-backed security?
A. Mortgage lenders originate loans and then sell packages of these loans in the
primary market.
B. Issuers of mortgage-backed securities buy their claim to the cash outflows
from the mortgages as loans are paid off.
C. It is an ownership claim in a pool of mortgages or an obligation that is
secured by such a pool.
D. Investors cannot buy and sell securitized mortgages like other bonds.
Total = 40 marks
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SECTION B: SHORT ANSWER QUESTIONS
Question 2 – Corporate Finance
Give three reasons why debt finance might be considered more attractive than equity
finance in the funding of a company acquisition.
(3 marks)
Question 3 – Equity Valuation and Analysis
Explain what is meant by economic recession and discuss the impact on the stock
market.
(4 marks)
Question 4 – Fixed Income Valuation and Analysis
Explain what is meant by a deep-discount bond and why an investor might be
interested in investing in such bonds.
(3 marks)
Question 5 – Corporate Finance
The management of Mambilla Powers Limited intends to expand its production
capacities. The initial capital outlay amounts to N300,000 (year 0). One year later (year
1) a storage site must be bought for N350,000. Starting in the first year, management
expects to generate a cash inflow of N210,000 for each year over the subsequent four
years (years 1 to 4). The opportunity cost of capital amounts to 12%.
5(a)
Calculate the NPV of the project.
5(b)
The Chief Finance Officer (CFO) has expressed fears that accepting the new
project might result in a reduction in the company’s sales revenue. He
estimates that the current sales revenue of N1 million yearly will decrease by
5%. Assuming the CFO is right, what would be your recommendation to the
company?
(4 marks)
5(c)
For this project, the company has spent N100,000 for research and
development during the past 12 months. How does this new fact change your
project evaluation?
(3 marks)
5(d)
How does the project value change if, at the beginning of the project, the
project will lead to an increase in net working capital amounting to N100,000
and, at the end of the project life time, will lead to a decrease in net working
capital by the same amount? (An explanation is sufficient. No calculations
necessary).
(3 marks)
5(e)
The CFO had recommended the use of 12% as cost of capital for the project in
5(a) above because this is the opportunity cost of capital for the existing
operations of the company. Is this appropriate? Justify.
(3 marks)
(3 marks)
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Question 6 –Equity Valuation and Analysis
Although many analysts consider the discounted cash flow methods to be theoretically
sound, they find its use in security valuation to be problematic.
Assume you belong to the group of analysts who would rather use the price-toearnings multiple (PE ratio, P/E ratio) to value and compare stocks. You find that the
P/E ratio method renders the equity valuation relatively easy and straight forward.
6(a)
List and discuss three factors that make the P/E ratio an attractive, and
therefore, widely used choice in pricing stocks and comparing the attractiveness
of different stocks.
(3 marks)
6(b)
Despite its ease, using P/E ratios for valuation is not free of problems. Discuss
briefly three potential problems associated with using P/E ratios for comparing
stocks in the same country.
(3 marks)
6(c)
You have collected the following information about Super Stores, a discount
retailer which is rapidly expanding in major Nigerian cities and Trendy Wares, a
high-end retailer of fashion clothing for men and women with presence in prime
retail locations in Lagos and Abuja:
Super
Stores
Historical and expected return on
14%
equity (ROE)
Historical and expected dividend
32%
payout ratio
Beta
1.30
NSE All Share Index
Expected return on index
Expected risk-free return
Trendy
Wares
16%
65%
1.15
10.5%
4.5%
6(c1)
Calculate the required rate of return for Super Stores and Trendy
Wares.
(3 marks)
6(c2)
Calculate the P/E (P0/E0) ratios using the earnings in the most recent
time period for both the companies.
(4 marks)
Hint:
DPS1
(r  g)
DPS1  EPS1  Payout ratio
P0 
DPS1  EPS 0  1  g   Payout ratio
6(c3)
On the Internet, you notice that Trendy Wares is trading at 20 times its
forecasted earnings. Calculate the long-term growth rate implied in
Trendy Wares’ current P0/E1 ratio.
(3 marks)
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Question 7 – Fixed Income Valuation and Analysis
You are the head of the Fixed Income department of an Investment Bank. One of your
clients, a high networth investor, Mr. Murphy has been attracted to the Nigerian bond
market and has earmarked N10,000,000 for fixed income securities. The investment
horizon is 5 years.
He is considering investment in one of the following:
Bond A - 12% Bonds of Ajaokuta Steel Limited (Face value N1,000) selling at par.
These Bonds will be redeemed at par after 5 years. Interest is payable
annually. YTM is 12%
Bond B - 14% Bonds of Jalingo glass Ltd. (Face value N1,000) selling at N1,100.
These Bonds will be redeemed at par after 7 years. Interest is payable
annually. Duration is 5 years.
Required:
7(a)
Compute the duration of Bond A; and analyze the interest rate risk of Bond A
and Bond B above, if the market interest rate increases by 1%.
(8 marks)
7(b)
You would like to help Mr. Murphy immunize the investment against any
immediate change in interest rates. Which one of the aforementioned
instruments will you recommend to him for this purpose? Give reasons.
(2 marks)
7(c)
State whether the investment recommended in 7(b) above offers perfect
immunization and also give conditions to be fulfilled for perfect immunization
of a bond investment.
(2 marks)
7(d)
Mr. Murphy recently heard about Mortgage Backed Securities (MBS), a relatively
new type of fixed income securities in Nigeria and wants you to educate him
more on it. You are required to write briefly on MBS highlighting the issues
below:
7(d1)
The meaning of (MBS) and how they differ from Asset Backed Securities
(ABS).
(3 marks)
7(d2)
How prepayment risk and credit risk impact on MBS.
(3 marks)
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