CHARTERED INSTITUTE OF
STOCKBROKERS
ANSWERS
Examination Paper 2.2
Corporate Finance
Equity Valuation and Analysis
Fixed Income Valuation and Analysis
Professional Examination
September 2013
Level 2
2
SECTION A: MULTI CHOICE QUESTIONS
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
B
C
C
B
C
B
A
C
C
C
B
A
C
A
C
A
C
A
B
C
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
D
B
C
C
B
C
C
C
D
C
C
B
D
D
A
A
C
A
D
C
3
SECTION B: SHORT ANSWER QUESTIONS
Question 2 – Corporate Finance
(i) It prevents dilution of ownership.
(ii) It leads to low cost when interest rates are low.
(iii) Interest payment is tax deductible.
(1 mark each for any 32 correct points) = (3 marks)
Question 3 – Equity Valuation and Analysis
Economic Recession is a significant decline in economic activity spread across the
economy lasting more than a few months. It is characterized by a decline in the real
GDP, real income, industrial production, wholesale and retail sales. Loss of employment,
factory and business closures, declining demands and increase in social tensions are
some of the matters that economist have to grapple with during the recessions.
(2 marks)
(Any two of the points below carries maximum of two marks)
1.
The prices of quoted equities get depressed as investors sell-off their equity holding
not necessarily to take profit but to have cash to meet demands for money for
spending to meet basic needs.
2.
Similarly, with recession, comes decreased demands and therefore earnings and
bottom-line of quoted companies.
3.
With declining profit levels and therefore ability for quoted firms to meet the needs
of investors who are attracted to the market for good returns, pricing of such stock
can only be astutely done at much lower multiples.
4.
Again, as income levels and employment levels drop, availability of investible funds
to likely investors will be reduced as investors struggle for survival. Investment
needs are therefore secondary.
5.
Moreover, with recession, purchasing power drops and company suffer huge unsold
stocks and therefore profitability worsening the growth potential of such stock.
6.
With economic recession comes weak market performance. The weaker a market,
the more difficult for companies to raise money by way of equity from the market.
Investors will be wary of staking their funds in the market with the result that new equities
may not be available for investors to place a bet on and existing equities that may be
weathering the recession may be over-priced and leave the market with the possibility of a
bubble for such equities.
Question 4 – Fixed Income Valuation and Analysis
A “deep discount” bond is also called a zero coupon bond. This is because all the returns on
the bond come in at maturity. It pays no coupon, and is issued at a large discount.
Why an investor might be interested:
(i) Tax advantage – since capital gains tax is usually lower than income tax.
(ii) It avoids reinvestment risk, if held to maturity.
4
(3 marks)
SECTION C: ESSAY TYPE, CALCULATION AND/OR CASE STUDY QUESTIONS
Question 5 – Corporate Finance
5(a):
Yr.
Cashflow
0
1
1-4
N
(300,000)
(350,000)
210,000
Discount
factor
@12%
1.000
0.8986
3.0374
PV
NPV
N
(300,000)
(312,500)
637,843
25,343
(3 marks)
Q5(b):
Yr.
Cashflow
0
1
1-4
N
(300,000)
(350,000)
160,000
Discount
factor
@12%
1.000
0.8986
3.0374
PV
NPV
N
(300,000)
(312,500)
485,984
(126,516)
The Project shows a negative NPV.
Working:
The impact of the reduction of revenue is 5% of N1,000,000 = N50,000
= N210,000 – N50,000
= N160,000
(4 marks)
Q5(c)
The N100,000 spent is “Sunk Cost”. It is not relevant in assessing this project.
(3 marks)
Q5(d):
The above scenario will lead to a reduction in the value of the project. The increase in
networking capital (NWC) is treated as an outflow at the beginning of the project.
The reduction in NWC is an inflow at the end of the project. Therefore, the present value of
the outflow is greater than the present value of the inflow resulting in an overall reduction in
value.
(3 marks)
5
Q5(e):
Whether this is appropriate or not would depend on the circumstances.
If the risk of the new project is similar to the risk of the existing operations of the company,
then, it is appropriate. However, if this is not the case it would be inappropriate to use 12%.
In this case, a project specific cost of capital should be estimated using the beta of a similar
project.
(3 marks)
Question 6 –Equity Valuation and Analysis
6(a):
i)
ii)
iii)
iv)
v)
Simple to Use
Helps investors to compare relative value of two stocks
Relates Market Price of a stock to its Earnings and can take forecast into account.
Provides Easy information for the valuation of a stock
It is related to the company's fundamentals and what the business generated for
shareholders.
Simplicity: It is an elegant valuation method that can easily be calculated without any
difficulty. Historical Earnings of Stocks are readily available and current prices of stocks are
readily available for the analyst to do his valuation of the stock relying on the metric.
Relativity: The PE Ratio relates the price that the market is currently paying for a stock to
the current earnings (Last 4 quarters) or projected earnings of the stock. This relative value
gives analyst the tool to easily compare two stock with similar earnings for cheapness and
otherwise.
Valuation: Since the PE ratio relates price to earnings, companies with higher PE will be
seem to be more expensive than those with lower PE ratios. What this means is that the
market can easily see that the money investors are willing and are paying for an equity
relative to its price would be used an indicator whether investors can consider such stocks
are being in the right time to invest or way for a correction on the stock price before taking
position on such stock.
(Any 3 of the points carries 1 mark each)
Q6(b):
6(b)
i)
ii)
iii)
iv)
v)
vi)
Only useful for companies making profit
Measurement and quality of Earnings to Use is also a problem
Does not take into account the gearing of companies
Earnings can easily be manipulated e.g. Arbitrage assumption
Does not considers cash generation by the business
Accounting policies may be manipulated and distort the estimation of earnings.
Q6(c1):
6(c1)
Required Return (r)
Super Stores
Return(r) =
Rf + β(Rm - Rf)
6
=
4.5% + 1.30(10.5% - 4.5%)
=
12.30%
Trendy Wares
Return(r) =
Rf + β(Rm - Rf)
=
4.5% + 1.15(10.5% - 4.5%)
=
11.40%
Q6(c2):
6(c2)
Super Stores
Trendy Wares
ROE
14%
16%
Payout ratio
32%
65%
Beta
Expec ted return on index (NSE)
Expec ted risk-free return
P/E
P/E
=
=
r
g
=
=
P/E
=
1.3
1.15
10.50%
10.50%
4.50%
4.50%
(D1/E1)/(r-g)
(payout ratio)/(r-g)
12.300%
9.520%
11.51
11.400%
5.600%
11.21
we know that,
Po =
Q6(c3):
6(c3)
P0
=
EPS1
Payout ratio
r
20
=
=
65%
11.40%
P0
EPS1
=
Payout
(r – g)
20
=
65%
(11.40% - g)
g
=
11.40% - 65%
20
g
=
8.15%
7
Question 7 – Fixed Income Valuation and Analysis
7(a):
Year
Cashflow
DF12%
PV of CF
PV (t)
1
120
0.893
107.16
107.16
2
120
0.797
95.64
191.28
3
120
0.712
85.44
256.32
4
120
0.636
76.32
305.28
5
1,120
0.567
635.54
3,175.20
999.60
4,035.24
NPV
Duration = 4,035.24
999.60
=
4.04 years
(4 marks)
Bond A:
Duration
= 4.04 years
Modified Duration, Dmod =
4.04
1 + YTM
=
=
4.04
1 + 0.12
3.607 years
We know that,
∆P
P
=
- Dmod
∆P
=
(- Dmod
=
(-3.607
=
-3.61%.P
x
Dk
x
x
Dk)
xP
0.01)
xP
That is, an increase in YTM by 1% will result in a 3.61% decrease in price.
(2 marks)
Bond B:
Duration
= 5 years
Modified Duration, Dmod =
5
1 + YTM
=
=
5
1 + 0.14
4.39 years
Also,
∆P
P
=
- Dmod
x
Dk
8
∆P
=
(- Dmod
x
Dk)
=
(-4.39
x
0.01)
=
-4.39%.P
xP
xP
That is, an increase in YTM by 10% will result in a 4.39% decrease in price.
(2 marks)
Q7(b):
7(b) To achieve immunization, which implies that the interest rate risk, the duration of the
asset must be set equal to the holding period of the investor. In this case, holding
period of the investor is 5 years, hence, Bond B with duration of 5 years is
recommended.
(2 marks)
Q7(c):
7(c) The investment alternative recommended in 7(b) above will give perfect immunization
if the following assumptions hold:
(i)
Here is no default risk of Bond B.
(ii) The buy and hold strategy is adopted.
(iii) There is only instantaneous change in interest rate during the investment
horizon.
(iv) The term structure is flat.
(2 marks)
Q7(d1):
7(d1) MBS are securities located from the pooling of mortgages and then sold to interested
investor, while ABS are located from the pooling of non-mortgage assets such as
credit card receivables, home equity loans, student loans and auto loans.
(3 marks)
Q7(d2):
7(d2) Prepayment risk is the risk of borrowers paying more than their required payment
thereby reducing the interest of the loan. This risk is higher if the current mortgage
rate is lower than the rate when the mortgage was first created.
Credit risk is the risk that principal and/or interest will not be paid as at when due.
MBS usually have a senior subordinate structure to deal with credit risk. The
subordinate or junior branches will absorb all of the losses, up to their value before
senior branches begin to experience losses.
(3 marks)
9