CIS September 2012 Exam Diet
Examination Paper 2.2:
Corporate Finance
Equity Valuation and Analysis
Fixed Income Valuation and Analysis
Corporate Finance (1 – 13)
1.
Assume a firm issues N1 billion in debt to repurchase shares. We would expect the
firm’s beta to:
A. Increase.
B. Stay the same.
C. Decrease.
D. None of the above.
2.
Which of the following statements concerning the principles underlying the capital
budgeting process is correct?
A. Cash flows are analyzed on a pre-tax basis.
B. Financing costs should be added to the required rate of return on the project.
C. Cash flows should be based on opportunity costs.
D. The net income for a project is essential for making a correct capital budgeting
decision.
3.
An analyst gathered the following data about a company:
Capital structure
50% debt
20% preferred stock
30% ordinary shares
Required rate of return
10% for debt
12% for preferred stock
16% for ordinary shares
Assuming a 30% tax rate, what after-tax rate of return must the company earn on
its investments?
A. 10.7%
B. 12.2%
C. 14.2%
D. 18.0%
4.
X Plc is an oil company with debt of N4,000,000 and equity of N10,000,000. Shares
in X Plc have a beta of 1.8. Assuming the applicable company income tax rate is
30%, what is the ungeared beta of X Plc shares?
A. 1.24
B. 1.41
C. 2.30
D. 2.68
5.
Which of the following statements is wrong about Modigliani-Miller proposition I?
A. This proposition is based on the efficient market hypothesis.
B. The value of a company doesn’t depend on the capital structure.
C. The cost of capital of a company doesn’t depend on the capital structure.
D. Leverage affects shareholders’ wealth.
6.
Which of the following is correct with regard to the graph below?
Net
Present
value
0
5%
10%
15%
Interest rate
I. The IRR is 10%
II. The NPV at 15% is positive.
III. As discount rates fall, project NPV rises.
A.
B.
C.
D.
I and II only.
I and III only.
II and III only.
All of the above.
7.
There are various theories concerning the dividend policy of companies. Which of the
following statements is wrong?
A. Dividend policy irrelevance means that investors prefer capital gains to
dividends.
B. Dividends are irrelevant only in a perfect world without taxes and transaction
costs.
C. Individuals in high tax brackets might prefer capital gains to dividends.
D. Individuals in low tax brackets might prefer dividends to capital gains.
8.
Which of the following statements is wrong?
A. The beta of a risk free-security is zero.
B. The expected return of a risk-free security is zero.
C. Beta is an index measure of systematic risk.
D. The expected return of a risky security can be lower than the risk-free return.
9.
Probability
20%
30%
NPV
N100
- N50
20%
20%
10%
N0
N125
N200
Knowing that the required rate of return for a project of comparable risk is 12%,
would you invest in this project?
A. Yes.
B. No.
C. I’m neutral whether the project is accepted or not.
D. It is not possible to decide based on the information given.
10. Given the following information from the financial statements of JFK Limited:
Profit before interest and tax
Depreciation
Taxes
Increase in new investments
Reduction 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
11. Which of the following statements is (are) true with respect to business risk?
I.
As the variable cost structure of a company increases, so will its degree of
business risk.
II. Business risk will increase the volatility of earnings relative to the volatility of
sales.
III. As the debt structure of a company increases, so will its business risk.
IV. During booming economic times, it is more logical to invest in companies with
greater degree of business risk.
A.
B.
C.
D.
I, II, and III only.
I and III only.
I, II, and IV only.
II and IV only.
12. ABC Co. is expecting its earnings to be N25 million for this current year. Its stated
dividend payout rate is 40%. There are 10 million shares outstanding, each trading
at N22. If, instead of paying dividends, the company decides to use that same
amount to repurchase its shares at N24, what will be the expected market price after
the repurchases have been completed? (Assume that the P/E ratio for ABC will
remain constant throughout this period).
A. N23.10
B. N23.78
C. N22.80
D. N22.97
13. Zuma 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 35% earnings as
dividends?
A. 7.7%
B. 13.5%
C. 14.3%
D. 62.9%
Equity Valuation and Analysis (14 – 26)
14. Which of the following is false regarding the differences between debt and common
stock?
A. Equity is ownership in a firm but debt is not.
B. Stockholders have voting power while creditors usually do not.
C. Periodic payments made to either class of security are tax deductible for the
issuer.
D. Interest payments are legally binding while dividend payments generally are not.
15. TPA Limited has just paid dividends of N3 per share. The earnings per share for the
company was N4. If you believe that the appropriate discount rate is 15%, and the
long term growth rate is 6%, then the firm’s P/E ratio is:
A. 8.33
B. 33.33
C. 44.44
D. 11.11
16. What should be the proper course of action for a company whose return on equity is
greater than the return required from its stockholders?
A. The company should reduce its dividends and plow more of its earnings back into
its operation.
B. The company should increase its dividends now that its profits are growing at a
faster rate.
C. The company should maintain the same level of dividends.
D. Dividend policy is irrelevant when it comes to this matter.
17. XYZ Corporation has an outstanding preferred stock with a stated dividend of N2.25.
The nominal risk-free rate of return is 5%, while the current inflation premium is
2%. If the credit spread on this issue is 3%, what should the current stock price of
these preferred shares be?
A. N28.13
B. N22.50
C. N75.00
D. N80
18. Which of the following statements incorrectly describes how structural changes may
affect industries?
I. Improvements in technology will benefit all industries in an economy.
II. A change in lifestyle is largely independent of economic cycles.
III. Structural changes have a much longer lasting impact on industries than would
cyclical changes.
A.
B.
C.
D.
I only.
II only.
I and II only.
II and III only.
19. Which of the following statements correctly define Market Value Added (MVA)? It is
___________
A. Net operating profit after taxes less capital charge.
B. Free cash flow to the firm adjusted for abnormal earnings.
C. The present value of all future economic value added (EVAs).
D. Free cash flow to equity.
Use the information below to answer questions 20 and 21:
Riverside Limited's last dividend was N1.55 and the directors expect to maintain the
historic 5 percent annual rate of growth. You plan to purchase the stock today because
you feel that the growth rate will increase to 8 percent for the next three years and the
stock will then reach N22.50 per share.
20. How much should you be willing to pay for the stock if you require a 15 percent
return?
A. N16.97
B. N18.90
C. N21.32
D. N32.63
21. How much should you be willing to pay for the stock if you feel that the 8 percent
growth rate can be maintained indefinitely and you require a 15 percent return?
A. N18.90
B. N19.28
C. N22.14
D. N23.91
22. Preferred stock is much like debt in that:
I. The payments on both are tax-deductible to the issuing firm.
II. Neither security is protected in the event of non-payment of promised cash
flows.
III. Neither security participates in any unexpected profits the firm generates.
A.
B.
C.
D.
I only.
II only.
III only.
I and III only.
23. The current price of XYZ stock is N80.00. Dividends are expected to grow at 5%
indefinitely and the most recent dividend was N2.75. What is the required rate of
return on XYZ stock?
A. 7.3%
B. 8.6%
C. 9.5%
D. 10.6%
24. You own 500 shares of FBN Plc, with a current market price of N60 per share. FBN
Plc received shareholder approval to split its stock under a 3-for-2 stock split. How
many shares do you now have and at what price?
A. 750 shares at N60 per share.
B. 1,500 shares at N30 per share.
C. 750 shares at N40 per share.
D. 1,500 shares at N20 per share.
25. For which of the following types of companies would the use of constant growth
dividend discount model be most appropriate?
A. A well-established company that operates in an industry that only has a few
participants, and all participants enjoy a moderate growth rate.
B. A new company that has a promising product that is expected to generate a very
high growth rate over the next few years.
C. A company which has a constant earnings growth rate, however, management
has indicated that they rather be bought out than to pay any dividends.
D. A company at the decline stage of the industry life-cycle.
26. The accounts of Intermobile Limited for the three month period to 31 December
2011 show a profit after tax of N726,580. 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
11% per annum.
What is the EVA for the three month period to 31 December 2011?
A. N154,580
B. N203,024
C. N583,580
D. N595,691
Fixed Income Valuation and Analysis (27 – 40)
27. A 10-year, 7.75% coupon, semi-annual payment bond with required return equal to
9% will:
A. Be priced at par value.
B. Be priced at a premium to par value.
C. Be priced at a discount to par value.
D. None of the above.
28. Based on the following spot rates:
Time
(Years)
1
2
3
4
Annual
Spot Rate
13.5%
11.5%
10.0%
9.0%
The one-year forward rate two years from now is closest to:
A. 7.0%
B. 7.6%
C. 10.3%
D. 10.0%
29. John, an investor preferring income to capital gains, is considering several 10-year
bonds that are all rated BBB and are quoted at the same ask price but have different
provisions in their indentures. If he expects that interest rates will fall sharply over
the next two years, John would most likely prefer a(n):
A. Inverse floater with a nonrefundable provision.
B. Floater with a cap.
C. Mortgage-backed bond.
D. Zero coupon bonds.
30. A bond with duration of 4.30 currently sells at N965. A 50 basis point decrease in
rates would cause the bond price to change by approximately:
A. -2.15%
B. 2.15%
C. 4.30%
D. -4.30%
31. Which of the following would result from an increase in expected interest rate
volatility?
A. Increase in price of both putable and callable bonds.
B. Decrease in price of both putable and callable bonds.
C. Increase in price of a putable bond and a decrease in price of a callable bond.
D. Need further information, especially maturity.
32. Suppose that the value of an option-free bond is equal to 100.16, the value of the
corresponding callable bond is equal to 99.42, and the value of the corresponding
putable bond is 101.72. What is the value of the call option?
A. 0.21
B. 0.64
C. 1.56
D. 0.74
33. A large grocery chain is re-evaluating its bonds since it is planning to issue a new
bond in the current market. The firm's outstanding bond issue has 6 years remaining
until maturity. The bonds were issued with a 6 percent coupon rate (paid semiannually) and a par value of N1,000. Because of increased risk the required rate has
risen to 10 percent.
What is the current value of these securities?
A. N569.50
B. N822.70
C. N899.00
D. N962.00
34. An investor is thinking of investing in one of the following bonds:
o Bond A is a 12 year, Baa-rated, 10% coupon, non-callable bond trading at 108;
o Bond C is a 12 year, A-rated, zero-coupon, non-callable bond tradition at 50.83;
o Bond D is a 25-year, 6% Treasury bond trading at par.
Which of these bonds has the least interest rate risk?
A. Information on holding period is needed.
B. Bond A.
C. Bond C.
D. Bond D.
35. What is an “investment-grade” bond?
A. A bond which does not have credit risk.
B. A bond which corresponds to the investment criteria of a client.
C. A bond with a rating above BB+
D. None of the above answers is correct.
36. Bond A has duration of 10.90 and bond B has duration of 8.75. An increase in
required return of 25 basis points:
A. Will cause a percentage increase in the price of A greater than the percentage
increase in the price of B.
B. Will cause a percentage increase in the price of B greater than the percentage
increase in the price of A.
C. Will cause a percentage decrease in the price of A larger in absolute value than
the percentage decrease in the price of B.
D. Will cause a percentage decrease in the price of B larger in absolute value than
the percentage decrease in the price of A.
37. Under what circumstances would a high-convexity bond be preferred to a low
convexity bond?
A. When the economy is in a recession.
B. In a low interest rate environment.
C. A bond that has a low convexity should always be preferred to a bond that has a
high convexity.
D. None of the above.
38. A 10-year, 8% coupon convertible bond is currently trading at N97.50. The
conversion price of the bond is N57.14. The underlying common stock of the same
issuer is currently paying a dividend of N1.65 and is priced at N48.95. Which of the
following would best estimate the market conversion premium per share of this
bond?
A. N8.19 per share.
B. N6.76 per share.
C. N5.13 per share.
D. N5.42 per share.
39. Contingent immunization:
I. Is a mixed-active passive bond portfolio management strategy.
II. Is a strategy whereby the portfolio may or may not be immunized
III. Is a strategy whereby if and when some trigger point value of the portfolio is
reached, the portfolio is immunized to insure an minimum required return.
A.
B.
C.
D.
I only.
I and II only.
II and III only.
All of the above.
40. Which of the following statements is (are) valid regarding the interest rate risk for
floating rate securities? The price of a floating-rate security will fluctuate because:
I.
The longer the time to the next coupon reset date, the greater the potential price
fluctuation.
II. The required margin that investors demand in the market changes.
III. A floating-rate security will typically have a cap.
A.
B.
C.
D.
I only.
I and II only.
II and III only.
All of the above.
Total = 40 marks
Question 2 – Corporate Finance
What is Management Buyout? State four (4) advantages.
(3 marks)
Question 3 – Equity Valuation and Analysis
Identify and briefly discuss three major pitfalls of the comparative valuation models for
equities.
(3 marks)
Question 4 – Fixed Income Valuation and Analysis
"Buy government bonds. You cannot lose money. They are guaranteed by the
government."
Do you agree? Briefly discuss.
(4 marks)
Question 5 – Corporate Finance
An analyst has forecast the free cash flows of Zebra Limited for the period 2012 to 2016
below. Zebra Limited plans to maintain its capital structure as at the end of 2011 well into
the future.
Forecast free cash flow for 2012 to 2016 (unit: 1 million Naira)
Fiscal year
Free cash-flows
2011
(Actual)
850
2012
2013
2014
2015
2016
901
955
1,012
1,073
1,137
5(a) Assume that the equity beta of Zebra Limited is 1.2, market risk premium is 5% and
cost of debt of Zebra Limited is 4%, which is equivalent to the current long-term
government bond yield as a proxy for the risk free rate. Calculate Zebra Limited's
weighted average cost of capital (WACC), assuming that at the end of 2011 Zebra
Limited's market value of equity is N10 billion, total interest-bearing debt N10 billion
and company income tax rate 30%.
(4 marks)
5(b) Assume that after 2016 Zebra Limited's free cash-flows will experience constant
growth at 3%.
5b1) Calculate the present value of free cash flows for the next 5 years (2012 to
2016).
(2 marks)
5b2) Calculate the terminal value at the end of 2016.
(2 marks)
5b3) Calculate the enterprise value of Zebra Limited at the end of 2011.
(2 marks)
5(c) Assume that instead of maintaining the capital structure as at the end of 2011 into
the future, Zebra Limited decided instead to change the capital structure, and have a
debt/equity ratio of 0.5
Compute the new equity beta and give a brief explanation for the change in equity
beta.
(6 marks)
Question 6 –Equity Valuation and Analysis
6(a) Tigerlinks Plc is considering a bid for Newday Plc. Both companies are listed on the
stock market and operate in the same business sector. Financial information on
Newday Plc, which is shortly to pay its annual dividend, is as follows:
Number of ordinary shares
Ordinary share price (ex div basis)
5 million
N33
Earnings per share
Proposed payout ratio
Dividend per share one year ago
Dividend per share two years ago
Equity beta
N4
60%
N2.30
N2.00
1·4
Other relevant financial information:
Average sector price/earnings ratio
Risk-free rate of return
Return on the market
10
4·6%
10·6%
Required:
6a1) Calculate the value of Newday Plc using the Price/earnings ratio method.
(4 marks)
6a2) Calculate the value of Newday Plc using the dividend growth model (where g=
historical geometric dividend growth rate).
(6 marks)
6(b) Discuss the significance, to Tigerlinks Plc, of the values you have calculated, in
comparison to the current market value of Newday Plc.
(6 marks)
Question 7 – Fixed Income Valuation and Analysis
On 30th June, 2010 a portfolio manager bought for N1 million (nominal) a bond of a major
company in Nigeria with the following characteristics: price 98, coupon 4.5% paid on an
annual basis with the 30/360 convention, the bond will be repaid at 100 on 30th June,
2014.
7(a) What was the total cost that the portfolio manager paid for N1 million nominal?
(2 marks)
7(b) Compute the yield to maturity of this bond (YTM) on the day the portfolio manager
bought the bond.
(4 marks)
7(c) In the first year during which the portfolio manager owned the bond, an
accumulation of negative news concerning the company was published. On 30th June,
2011 the CEO of the company resigned unexpectedly creating a panic sell in the
market. The YTM of the bond suddenly jumped to 14%.
How can you explain such a sudden jump? Is there any relationship with the term
structure of interest rates? Justify your answer.
(3 marks)
7(d) Compute the new theoretical price of the bond on 30th June, 2011.
(3 marks)
7(e) Two months later, on 31st August, 2011 the portfolio manager thought that the bond
was too risky for his portfolio and decided to sell it. At that time the bid-ask price of
the bond on the market was 70-75.
Which price will you apply for the sell? Why?
7(f)
(2 marks)
Coupon
Price
YTM
Macaulay’s Duration
(in years)
Bond A
5.25%
98.54%
2.50%
2
Bond B
5.50%
100.00%
2.70%
3
The modified duration of the bond sold was 2.34. The portfolio manager wants to
keep the same modified duration and therefore decides to reinvest the cash of the
sale into two Federal Government bonds (A and B). What percentage of each bond
will the portfolio manager have to invest in order to get a modified duration of 2.34?
(4 marks)
END OF PAPER
FORMULAE
Levered/unlevered beta:
Annuities:
Yield to maturity of a bond:
Valuation of perpetual bonds:
Price change approximated with duration:
Portfolio duration:
Macaulay duration: