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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. 5 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 6