CHARTERED INSTITUTE OF
STOCKBROKERS
ANSWERS
Examination Paper 2.2
Corporate Finance
Equity Valuation and Analysis
Fixed Income Valuation and Analysis
Professional Examination
September 2012
Level 2
1
SECTION A: MULTI CHOICE QUESTIONS
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
A
C
A
B
D
A
A
B
A
C
D
D
C
C
A
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
A
A
A
C
B
D
C
B
C
A
C
C
A
A
B
31
32
33
34
35
36
37
38
39
40
C
D
B
B
C
C
D
B
D
D
(40 marks)
SECTION B: SHORT ANSWER QUESTIONS
Question 2 – Corporate Finance
An MBO is a form of acquisition where a company’s existing managers acquire a large
part of all the company from either the parent company or from the private owners.
(1 mark)
Advantages
i. It ensures smooth continuation of the business since the new owners understand the
business.
ii. Employees – turned owners often demonstrate increased motivation and
commitment.
iii.
The new managers/owners are often better accepted by the employees.
iv.
Financial partners such as banks are generally reassured by the expertise of the
management in place.
v.
Employees turned owners have a good idea of what they are buying.
1 mark each (any 3 points) (3 marks)
Total = 4 marks
2
Question 3 – Equity Valuation and Analysis
i. The approach to valuation is simplistic and does not analyse critical factors that drive
value.
ii. It is static as it represents a snapshot of where a firm is at a point in time but fails to
capture the dynamic nature of business and competition.
iii. It is difficult to compare two companies because there are so many reasons why
multiples can differ. For example, different accounting policies resulting in different
reported earnings.
iv. If the peer group as a whole is incorrectly valued (e.g. during a stock market bubble),
the resulting multiples will also not be realistic.
v. Multiples are based on historic data or forecasts, they therefore have a
short-term focus.
1 mark each for any 3 points
(3 marks)
Question 4 – Fixed Income Valuation and Analysis
Bonds issued by government are backed by the full faith and credit of the government
(1 mark)
and therefore considered to have no credit risk. (1 mark)
However all types of bonds are faced with several other types of risks such as:
 Interest rate risk
 Re-investment risk
 Inflation risk
 Market risk
 Selection risk e.t.c
(1 mark)
Therefore an investor who buys government bonds can still lose money through
exposure to some of the risks listed above.
(1 mark)
Total = 4 marks
3
SECTION C: ESSAY TYPE/CALCULATIONS
Question 5 – Corporate Finance
5(a) Cost of debt = 4%
Cost of Equity (using CAPM)
Kε =
Rf + (Rm – Rf) β
=
4% + 5% X 1.2 = 10%
WACC =
Ve
Ve + Vd
x
= 10 x 10%
20
=
Ke +
+
(1 mark)
Vd
Ve + Vd
x Kd (1-t)
10 x 4% (1 - 0.3)
20
5% + 1.4% = 6.4%
(1 mark)
(1 mark)
(1 mark)
5(b1)
901
+ 955
+ 1012 + 1073 + 1137
(1.064)1
(1.064)2
(1.064)3 (1.064)4 (1.064)5
=
Yr
2012
C/F
901
D/F @ 6.4%
0.9398
PV
846.76
2013
955
0.8833
843.55
2014
1012
0.8302
840.16
2015
1073
0.7802
837.15
2016
1137
0.7333
833.76
4, 201.38
(2 marks)
5(b2)
T.V = FCF2016 (1 + g)
WACC - g
= 1137 (1 + 0.03) = 1171.11
0.064 – 0.03
0.034
= 34, 444.41
(2 marks)
4
5(b3)
= PV of free cash flows from 2012 to 2016
+ PV of Terminal value
= 4, 201.38 + 34,444.41
(1.064)5
= 4,201.38 + 25,258.09
= N29, 459.47
(2 marks)
5(c)
Ungear the Equity beta to determine the asset beta
Β asset =
=
=
β equity
D
[1 + (1-t) /E]
1.2
[1 + (1 – 0.3) x 1]
(1/2 mark)
(1/2 mark)
=
1.2
1.7
0.71
(1 mark)
(1 mark)
D
Regear the asset beta based on the new /E ratio
(1 mark)
D
New β equity = β asset x [1 + (1-t) /E]
= 0.71 x [1 + (1 - 0.3) 0.5]
(1 mark)
= 0.71 x 1.35
= 0.96
(1 mark)
5
Question 6 – Equity Valuation and Analysis
6(a1)
Price
= 10
Earning
(1 mark)
Price = 10 x Earnings
(1 mark)
= 10 x N4 x 5 million shares
= N 200 million
(2 marks)
6(a2)
Compute g
Current dividend = 60% x N4 = N2.4
2.00 (1 + g) 2 = 2.4
(1 + g) 2 = 2.4
2.0
g = (√2.4/2.0) – 1 = 0.095445
Ω 9.5%
(2 marks)
Compute cost of Equity
KE = Rf + (Rm – Rf) β
= 4.6% + (10.6 – 4.6)1.4
=
13%
(2 marks)
VE = D0 (1 + g)
KE – g
= 2.628
0.035
=
= 2.4 (1.095)
0.13 – 0.095
N75
N 75 x 5million shares = N375 million
(2 marks)
6
6(b)
The current market price of Newday is (N33 x 5million shares) = N165 million, while
P/E ratio and dividend discount valuation models give a figure of N200 million and
N375 million respectively.
This may suggest that Newday is currently undervalued. Perhaps the market is yet to
discover the hidden potentials of the company.
Because the valuation based on dividend growth model is significantly higher than the
current market value, it is advisable to revisit the cost of equity and expected
dividend growth rate used in the computation as they could be inaccurate.
The price earnings ratio valuation appears to be closer to the amount Tigerlinks would
likely pay to acquire Newday Plc, as the shareholders would want some inducement to
sell.
P
A premium of about N35 million is reflected by the /E valuation model.
(6 marks)
Question 7 – Fixed Income Valuation and Analysis
7(a)
98 x N1, 000,000 = N980, 000
100
(2 marks)
7(b)
4.5
+
4.5
+ 4.5
+ 4.5 + 100
(1 + YTM)
(1 +YTM)2 (1 + YTM)3
(1 + YTM)4
Using the trial and error method or financial calculator, calculate the IRR of this cash flow.
YTM = 5.065%
(4 marks)
7(c)
There is no direct relationship with the term structure of interest rates. The sudden jump
is as a result of the widening of the credit spread because the market is reacting to the
situation of the company. In order words, the market perceives an increase in credit risk
and therefore requires a higher YTM.
(4 marks)
7
7(d)
The bond now has 3 years to maturity and a new YTM at 14%.
4.5
(1.14)1
+
4.5
+
(1.14)2
104.5
(1.14)3
= 77.94
(3 marks)
7(e)
The bond is being sold, so we must use the bid price (most unfavourable price) which in
this case, is 70.
(2 marks)
7(f)
Let x = proportion invested in Bond A
X.
2
+ (1-X)
3
1.025
1.027
= 2.34
X = 59.92%
1 – X = 40.08%
i.e invest 59.92% in Bond A and 40.08% in Bond B
(2 marks)
8