CHARTERED INSTITUTE OF
STOCKBROKERS
ANSWERS
Examination Paper 1.2
Corporate Finance
Equity Valuation and Analysis
Fixed Income Valuation and Analysis
Professional Examination
September 2011
Level 1
1
SECTION A: MULTI CHOICE QUESTIONS
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
D
A
B
D
D
B
D
D
A
A
D
B
D
D
B
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
B
A
C
D
B
B
D
C
D
A
C
B
D
A
D
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
A
C
A
A
A
B
D
B
B
D
C
B
C
C
A
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
B
C
A
A
D
D
A
D
B
A
D
A
D
A
C
(60 marks)
SECTION B: SHORT ANSWER QUESTIONS
Question 2 - Corporate Finance
i.
Funding needs of the firm.
ii.
Liquidity.
iii.
Ability to borrow.
iv.
Restrictions in debt contracts (protective covenants).
v.
Control.
vi.
Legal/ regulatory rules, for example capital impairment rules.
Any six points ½ mark each
Total = 3 marks
Question 3 – Equity Valuation and Analysis
i.
To expand the ownership and control base.
ii.
To alter the capital structure i.e to reduce gearing.
iii.
To enhance borrowing capacity.
iv.
To increase ‘permanent’ capital.
(1 mark each for any four point)
Total = 4 marks
2
Question 4 – Fixed Income Valuation and Analysis
Macaulay Duration is the number of years required to recover the true cost of a bond,
considering the present value of all coupon and principal payments received in the
future. It measures the average life of a bond.
It ignores any embedded options in the security and assumes a flat yield curve.
(1 ½ marks)
Modified Duration expands or modifies Macaulay duration to measure the responsiveness
of a bond’s price to interest rate changes. It is defined as the percentage change in price
for a 100 basis point change in interest rates. This concept assumes that the cash flows
of the bond do not change as interest rates change (which is not the case for most
callable bonds).
(1 ½ marks)
Total = 3 marks
SECTION C: COMPLUSORY QUESTIONS
Question 5 - Corporate Finance
5(a)
NPV
The value of the stock is the present value of its cash flows, or (N 180 + 7)/1.12 =
N166.96.
According to the NPV criterion, invest if NPV is greater than zero. The NPV of investing in
Stock B is – N165 + 166.96 = N1.96. Since NPV is positive, Stock B is undervalued and
investors should buy it.
(2 marks)
IRR
Using the trial and error method, determine the IRR = 13.33%
The IRR criterion states than an investment should be made if its IRR is greater than the
cost of capital. The cost of capital for Stock B is its required return (12%). The required
return is determined by the opportunity cost principle: other assets with the same risk
are expected to return 12%, so investors will require the same expected return from
Stock B. Since the IRR (expected return) exceeds the cost of capital, Stock B is priced to
provide an expected return that more than compensates for its risk. Stock B is a bargain
and should be purchased.
(3 marks)
Total = 5 marks
3
5(b)
WACC =
. Kd (1- t)
Vd
Vd + Ve
+
Ve
Vd + Ve
. Ke
(½ mark)
Ve = 10 million x N2.40 = N24 million
(½ mark)
Vd = N40 million x N120/N100 = N48 million
(1 mark)
Ke = 12%
Kd (1- t) = 9% (1- 0.20) = 7.2%
WACC =
= 4.8%
48
72
X 7.2%
+
(1 marks)
24
72
X 12%
(1 marks)
+ 4%
WACC = 8.8 %
(1 marks)
Total = 5 marks
Question 6 - Equity Valuation and Analysis
6(a1)
7% growth rate
P0 = D1/(KE – g) and D1 = D0(1 + g)
P0 = 1.70(1 + .07)/(.12 – .07) = N36.38
(2 marks)
6(a2)
10% growth rate
P0 = 1.70(1 + .10)/(.12 – .10) = N93.50
6(a3)
(2 marks)
From the above results it can be deduced that, all other things being equal, the higher
the rate of growth of dividend, the higher the value of a firm’s shares.
(2 marks)
6(b)
The Price to sales ratio (Price/Sales or P/S) is a valuation metric for stocks. It is
calculated by dividing the company's market capitalization by the company's revenue in
the most recent year; or, equivalently, divide the per-share stock price by the per-share
revenue. The lower the ratio, the more attractive the investment.
(2 marks)
4
For instance, to value an unlisted company PQR Limited, we may take the P/S ratio of
similar listed companies as a basis of making an estimate:
P/S ratio of similar companies = 2.5 times
Sales per share of PQR = N5
Value of PQR shares is derived as follows:
P/S = 2.5
P = 2.5 X N5 = N12.5/ share.
P/S ratio is more stable, and therefore more reliable than the P/E ratio.
(2 marks)
Total = 10 marks
Question 7 - Fixed Income Valuation and Analysis
7(a)
The "term structure" of interest rates refers to the relationship between bonds of
different time to maturity (term). When interest rates of bonds are plotted against their
terms, this is called the "yield curve". Economists and investors believe that the shape of
the yield curve reflects the market's future expectation for interest rates and the
conditions for monetary policy.
(1 marks)
The following theories attempt to explain how yields vary with maturity.
1. The local expectations hypothesis states that all bonds (of similar nature
except maturities), regardless of maturity, will have the same expected holding
period rate of return. That is, a one-month bond and a 30-year bond should, on
average, provide the same rate of return if you buy a one-month bond and hold it
to maturity or buy a 30-year bond and sell it after one month.
2. The unbiased expectations hypothesis states that the current implied forward
rates are unbiased estimators of future expected spot rates. Therefore, if the
yield curve is upward sloping, the market expectation is that rates will rise.
3. The liquidity preference hypothesis states that the yield curve should
normally be upward sloping, reflecting investors ‘preferences for the liquidity and
lower risk of shorter-term securities. In its purest form, the theory is invalidated
by casual observation of the historical behavior of term structure. That is, there
have been numerous occasions when the yield curve has been inverted.
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4. The market segmentation hypothesis states that for each maturity there
exists an entirely separate market. For example, banks tend to participate
exclusively in the short-maturity spectrum, whereas insurance companies tend to
participate exclusively in the long-maturity spectrum of term structure because
they have long-term obligation. Thus, supply and demand considerations of
participants within each segment of the term structure will determine solely the
equilibrium interest rate without any regard to where the equilibrium is in the
neighboring maturities.
5. Preferred habitat theory is a variant of the market segmentation theory, and
states that in addition to interest rate expectations, investors have distinct
investment horizons and require a meaningful premium to buy bonds with
maturities outside their "preferred" maturity, or habitat. Proponents of this theory
believe that short-term investors are more prevalent in the fixed-income market,
and therefore longer-term rates tend to be higher than short-term rates, for the
most part, but short-term rates can be higher than long-term rates occasionally.
(2 marks each for any two = 4 marks)
7(b)
Calculation of Macaulay duration
Time (years) 1 2 3 4 Cash flow 8 8 8 108 PV factor @ 7%
0.935
0.874
0.817
0.763
PV of coupon payment 7.48
6.99
6.53
82.43
103.43
Time weighted PV (Time x PV of coupon paymt ) 7.48 13.98 19.60 329.72 370.78 Duration = 370.78/103.43 = 3.58 years
(5 marks)
Total = 10 marks
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