CIS September 2011 Exam Diet
Examination Paper 2.2:
Corporate Finance
Equity Valuation and Analysis
Fixed Income Valuation and Analysis
Corporate Finance (1 – 13)
1.
Consider the following statements concerning sources of finance:
I. Retained earnings represent a free source of finance for a business.
II. Convertible loan notes are normally issued at a lower rate of interest than nonconvertible loan notes.
III. Under an operating lease, the lessor is responsible for the upkeep of the asset.
IV. Under an invoice discounting arrangement, the invoice discounter will collect the
receivables on behalf of the client.
Which of the above statements are correct?
A. I and II
B. I and III
C. II and III
D. III and IV
2.
Aldan Co has 2 million N0·50 ordinary shares in issue and the market capitalisation of
the company is N28·0 million. The company is about to make a 1-for-4 scrip issue,
immediately followed by a 2-for-1 share split.
What will be the theoretical value of a share following the above transactions and the
number of shares held by an investor that held 1,000 shares prior to these transactions?
A.
B.
C.
D.
Share value
following
transactions
No of shares held
following
transactions
N14·00
N5·60
N8·75
N1·87
2,500
2,500
625
7,500
3.
Which of the following statements about asset-backed securities (ABS) is incorrect?
A. ABS are securities which are backed by cash flows from a variety of financial assets.
B. The process of creating ABS is called securitization.
C. Credit enhancement could transform an ABS to a security with considerably lower
credit risk compared with the financial assets backing the security.
D. None of the above.
4.
A takeover defensive strategy whereby the target company makes a counter bid for the
stock of the bidder is described as:
A. Poisson pills.
B. Greenmailing.
C. Pacman defence.
D. Macaroni strategy.
5.
The following methods of issuing shares may be used by a quoted company:
I.
II.
III.
IV.
6.
An offer for sale.
An offer for subscription.
A rights issue.
A placing.
Which of the above methods allow the investing public to participate in the share issue?
A. I and II
B. II only
C. III and IV
D. IV only
The shares of Fashion Limited have a beta of 0·6 and the shares of Style Limited a beta
of 1·5. Investors in Fashion Limited have an expected rate of return of 8% and the
expected returns to the market are 10%.
Using the Capital Asset Price Model, what will be the expected rate of return for
investors in Style Limited?
A. 7·5%
B. 12·0%
C. 12·5%
D. 20·0%
7.
Papa Limited is financed by 400,000 N1 equity shares with a current market value of
N4·20 per share, and N800,000 of 5% loan notes, which are currently trading at N78 per
N100 nominal value. The cost of equity is 12%, and 30% corporate tax rate is
applicable.
What is the weighted average cost of capital (WACC) of Papa Limited?
A. 6.33%
B. 7.33%
C. 9.70%
D. 10.10%
8.
Consider the following statements concerning dividend policy:
I.
The traditional view states that dividends should not be paid unless the company
has excess cash flow.
II. The Modigliani and Miller view (without taxes) states that dividend policy is
irrelevant to shareholder wealth.
Which one of the following combinations (true/false) concerning the above statements is
correct?
A.
B.
C.
D.
9.
Statement 1
True
True
False
False
Statement II
True
False
True
False
Consider the following statements:
I.
A beta factor measures the relationship between market returns and the returns of
an individual security.
II. A share that has a beta of 1·0 will have an expected return equal to the risk-free
rate.
Which ONE of the following combinations (true/false) concerning the above statements
is correct?
Statement I
Statement II
A. True
True
B. True
False
C. False
True
D. False
False
10. Peninsula Limited Co buys materials from its suppliers on eight weeks’ credit. The
materials are delivered immediately and held for two weeks before being issued to
production. The production process takes five weeks and the finished goods are held for
four weeks before being sold. All customers are allowed four weeks’ credit but take
seven weeks to pay.
How long is the operating cash cycle of the business?
A. 7 weeks.
B. 10 weeks.
C. 18 weeks.
D. 25 weeks.
11. An analysis of the financial statements of Orlando Limited revealed the following:
I.
II.
III.
IV.
A
A
A
A
higher than average inventory holding period.
lower than average acid-test ratio.
higher than average payment period for trade payables.
lower than average sales to fixed assets ratio.
Which two of the above is consistent with overtrading?
A. I and II
B. I and IV
C. II and III
D. III and IV
12. The higher risk of a project can be allowed for by decreasing:
A. The cost of the initial investment of the project.
B. The required rate of return of the project.
C. The internal rate of return of the project.
D. The estimates of future cash inflows from the project.
13. Which of the following is true concerning warrants?
A. They are often issued along with common stock as a method of reducing the interest
rate associated with the issue.
B. They are considered to be good quality investment even if the company’s common
stock is considered to be speculative.
C. They are securities that may cause outstanding shares to decrease.
D. They are long term options to buy shares at a fixed price from the issuing company.
Equity Valuation and Analysis (14 – 26)
14. Taraba Investment Limited has ordinary shares in issue with a par value of N0·25. For
the financial year just ended, the company had earnings per share of N0·20 and a
dividend cover of 2·0 times. At the year end the dividend yield was 4·0%.
What is the price/earnings ratio of the company at the year end?
A. 2·0 times.
B. 8·0 times.
C. 12·5 times.
D. 25·0 times.
15. What is earnings management?
A. A situation where management makes changes in the operations of the firm to
ensure that earnings do not increase or decrease too rapidly.
B. A situation where management makes changes in the operations of the firm to
ensure that earnings do not increase too rapidly.
C. A situation where management makes changes in the operations of the firm to
ensure that earnings do not decrease too rapidly.
D. It is the practice of using flexible accounting rules to improve the apparent
profitability of the firm.
16. An analyst made the following statement: ’’compared with price-to–earnings ratios,
price-to-sales ratios and price-to-cash-flow ratios are generally less subject to distortion
or manipulation’’.
The analyst’s statement is correct with respect to:
A. Price-to-sales ratios but not price-to-cash flow ratios.
B. Price-to-cash-flow ratios but not price-to-sales ratios.
C. Both price-to-sales ratios but not price-to-cash flow ratios.
D. Neither price-to-sales ratios nor price-to-cash flow ratios.
17. Market value added (MVA) could be defined as:
A. The present value of all future economic value added (EVAs).
B. Net operating profit after taxes less capital charge.
C. Free cash flow to the firm adjusted for abnormal earnings.
D. Free cash flow to equity.
18. Which of the following statement is (are) true with respect to a company's
of its free cash flow?
calculation
I.
Firms in the declining phase of their life cycle will generally have high levels of free
cash flows relative to the market at large.
II. Discretionary free cash flow is that which would be available once capital
expenditures are deducted from cash flow from investing activities.
III. Free cash flow available to the owners of a company can be measured as the cash
that is left once the cash that is used for investing activities is deducted from the
cash that is made available from operations.
IV. If a company is financially sound, its operating cash flows should always be higher
than its net income.
A.
B.
C.
D.
I, III, and IV only
I and II only
II and IV only
II only
19. You wish to earn a return of 11% on each of two stocks, C and D. Stock C is expected to
pay a dividend of N3 in the upcoming year while Stock D is expected to pay a dividend
of N4 in the upcoming year. The expected growth rate of dividends of both stocks is 7%.
Which of the following statements is correct about the intrinsic value of stock C?
A. It will be greater than the intrinsic value of stock D.
B. It will be the same as the intrinsic value of stock D.
C. It will be less than the intrinsic value of stock D.
D. It cannot be calculated without knowing the market rate of return.
20. One of the problems with attempting to forecast stock market values is that:
A. There are no variables that seem to predict market return.
B. The earnings multiplier approach can only be used at the firm level.
C. The level of uncertainty surrounding the forecast will always be quite high.
D. Dividend payout ratios are highly variable.
21. Gold Mining Plc is expected to pay a dividend of N8 in the coming year. Dividends are
expected to decline at the rate of 2% per year. The risk-free rate of return is 6% and
the expected return on the market portfolio is 14%. The stock of Gold Mining Company
has a beta of -0.25. What is the intrinsic value of the stock?
A. N80.00
B. N133.33
C. N200.00
D. N400.00
Use the information below to solve questions 22 and 24:
Consider the free cash flow approach to stock valuation. Utica Manufacturing Company is
expected to have NOPAT of N280, 000 in the coming year. The firm's corporate tax rate is
30%. It is expected that N200, 000 of operating cash flow will be invested in new fixed
assets. Depreciation for the year will be N100, 000. After the coming year, cash flows are
expected to grow at 6% per year. The appropriate discount rate is 15% per year. The firm
has no outstanding debt.
22. Compute the projected free cash flow of Utica Manufacturing Company for the coming
year.
A. N150,000
B. N180,000
C. N300,000
D. N380,000
23. What is the total value of the equity of Utica Manufacturing Company?
A. N1,000,000
B. N2,000,000
C. N3,000,000
D. N4,000,000
24. The goal of fundamental analysts is to find securities:
A. Whose intrinsic value exceeds market price.
B. With a positive present value of growth opportunities.
C. With high market capitalization rates.
D. All of the above.
25. Which of the following do financial analysts consider least important when assessing
the long-run economic and financial outlook of a company?
A. General economic conditions.
B. Prospects of the relevant industry
C. Expected return on equity.
D. Expected changes in EPS.
26. You project that the economy is going into a recession, and would like to purchase a
stock that would generate high returns during recession. Buying which of the following
categories of stocks would most likely help you achieve your objective?
A. Cyclical stocks.
B. Counter-cyclical stock.
C. Defensive stocks.
D. Value stocks.
Fixed Income Valuation and Analysis (27 – 40)
27. A Collaterized Mortgage Obligation (CMO) issue consists of three tranches: One has an
average life of 2 years, the second an average life of 10 years and the third an average
life of 30 years. Initially, interest payments received will be distributed:
A. First to the holders of the 2-year tranche.
B. First to the holders of the 10-year tranche.
C. First to the holders of the 30-year tranche.
D. Equally to all bond holders.
28. One of your friends holds a callable bond, and seeks to understand the implications of
the call feature. Which of the following is generally true if a company calls its bonds?
A. The company increases its debt to net worth ratio.
B. The creditworthiness of the company declines.
C. The bond holders receive a premium over par.
D. The bond holder gains since the bond being called gives him the opportunity to
reinvest the proceeds.
29. A bond was issued at par and was purchased by the holder. If the bond has a 7%
coupon and is currently selling at 92.50, what is the current yield?
A. 7%
B. 7.5%
C. 8%
D. 8.5%
30. A portfolio consists of 2 bonds:
Maturity
Coupon
Duration
Proportion in Portfolio
Bond A
10 Years
8%
6.7
60%
Bond B
7 Years
5.20%
3.9
40%
Which of the following is the best measure of portfolio duration?
A. 5.30
B. 5.58
C. 3.71
D. 8.50
31. Which of the following statements is/ are true of floating rate notes (FRNs)?
I.
FRNs are long term securities wherein coupons are adjusted periodically according to
changes in a benchmark rate.
II. Inverse floaters are FRNs whose floating rate is inversely related to the coupon of
the bond.
III. FRNs note holders are exposed to interest rate risks more than straight bondholders.
A.
B.
C.
D.
I and II only
I and III only
II and III only
I, II, and III
32. Which of the following statements is (are) true with respect to reinvestment rate risk?
I.
Premium bonds will have lower reinvestment rate risk than discount bonds holding
all other factors constant.
II. If held to maturity, zero coupon bonds have no reinvestment rate risk whatsoever.
III. The longer the maturity of the bond, the greater will be its reinvestment rate risk.
IV. The greater the frequency of coupon payments, the lower will be the reinvestment
rate risk.
A.
B.
C.
D.
I, III, and IV only
III and IV only
I, II and IV only
II and III only
33. You are an investor preferring income to capital gains. You are considering several 10year bonds that are all rated BBB and are quoted at the same ask price but have
different provisions in their indentures. If you expect that interest rates will fall sharply
over the next two years, which of these fixed income instruments would you prefer?
A. Floater with a cap
B. Mortgage-backed bond
C. Zero coupon bonds
D. Inverse floater with a non-refundable provision
34. Which of the following best describes negative convexity?
A. The tendency of the callable bond price to rise less quickly than that of an equivalent
straight bond when interest rates fall.
B. The fact that the actual price change of a bond is always greater than that predicted
by modified duration.
C. The fact that there is an inverse relationship between bond price changes and yield
changes.
D. The fact that longer maturity bonds normally attract higher yields.
35. You observe an inverted yield curve in the bond market. Which of the following best
describes the market expectation about the economy?
A. The market expects a solid economic growth in an inflationary environment.
B. The market expects a strong deceleration of the economy in a non-inflationary
environment.
C. The market expects future economic stability.
D. An inverted yield curve can never arise.
36. You are an independent investment adviser. Your client is primarily seeking capital gains
in the fixed income market. Under which of the following conditions would you advise
him to buy bonds?
A. When interest rates are high and are expected to drop.
B. When the interest rates are stable and are expected to remain stable.
C. When interact tares are high and are expected to fall.
D. When bond prices are low and interest rates are expected to rise.
37. Which two of the following would be the most attractive feature of a new bond issue
from the investor’s point of view?
I.
II.
III.
IV.
A
A
A
A
low call price.
high call price.
low coupon rate.
high coupon rate.
A.
B.
C.
D.
I and III
I and IV
II and III
II and IV
38. There are three identical bonds A, B and C, except that bond A is a bullet bond (noncallable), B is callable at par, and C is putable at par. Which of the following statements
about the prices of bonds A, B and C is true?
A. The prices of bonds A, B and C are exactly equal.
B. The Price of bond A is greater than the price of bond B.
C. The price of bond B is greater that the price of bond A and C.
D. The price of bond C is the least of the three.
39. Suppose the interest rate curve has a parallel shift down wards; which of the following
bonds will experience the highest price appreciation?
A. A 5-year fixed rate bond with duration of 4-years.
B. A floating rate note linked to short-term rates.
C. A 10-year zero coupon bond.
D. Indeterminable.
40. The yield spread of a particular bond depends on which of the following?
I. Embedded options.
II. Creditworthiness of the issuer.
III. Maturity of the instrument.
A.
B.
C.
D.
I only
III only
II and III
I, II and III
Total = 40 marks
Question 2 – Corporate Finance
Why is it that in corporate finance emphasis is placed on cash flow rather that profit in the
evaluation of projects?
(3 marks)
Question 3 – Equity Valuation and Analysis
Financial analysts believe that the quality and depth of a company’s management is an
important criterion in assessing a stock’s value. Briefly enumerate how analysts assess the
quality and depth of a firm’s management?
(3 marks)
Question 4 – Fixed Income Valuation and Analysis
Investment in fixed income instruments is subject to several risks, including the possibility of
unexpected changes in price. Mention three reasons why bond prices change.
(4 marks)
Question 5 – Corporate Finance
Bassy and Sons Limited is reviewing investment proposals that have been submitted by
divisional managers. The investment funds of the company are limited to N800,000 in the
current year. Details of three possible investments, none of which can be delayed, are given
below.
Project 1
An investment of N300,000 in a software package which would lead to savings in
labour costs. The expected savings are as follows:
Year
Cash flows (N'000)
1
85
2
90
3
95
4
100
5
95
Project 2
An investment of N450,000 expected to reduce administration costs by N140,800 per
annum for the next five years.
Project 3
The project requires an investment of N400,000 in new equipment. This will result in some
net cash savings, and ultimately a positive NPV of N77,791 for the project.
A cost of capital of 12% is applicable and taxation should be ignored.
Required
5(a1) Compute the Net present value of projects 1 and 2.
(4 marks)
5(a2) Determine the best way for Bassy and Sons Limited to invest the available funds and
calculate the resultant NPV on the assumption that each of the three projects is divisible.
(4 marks)
5(a3) Discuss the reasons why capital rationing may arise.
(4 marks)
5(b) JKL Plc, a purely equity-financed road transport company, has a firm beta of 1.2. The
risk free rate is 6 per cent and the market risk premium (Rm – Rf) is 5 per cent. It is
considering adding two new divisions: a shipping division with a beta of 1.4 and a
warehousing division with a beta of 0.9.
5(b1)
Calculate the new beta of JKL Plc if it decides to go ahead with the two new divisions.
The new company’s value would be 80 per cent in the road transport, 15 per cent in
the shipping and 5 per cent in the warehousing divisions. (2 marks)
5(b2)
JKL Plc is considering a fourth division, air freighting, which has a beta of 1.1 and
offers an expected rate of return of 10 per cent. Should the firm engage in this new
line of business?
(2 marks)
Question 6 – Equity Valuation and Analysis
6(a) Multiproduct Limited and Megabucks Limited are the two leading conglomerates
operating in Gloryland. Due to stiffer regulatory regime and uncertainty regarding the
future of Multiproduct Limited and Megabucks Limited, the Directors of both companies
are considering a proposal to merge their companies and exploit the possibilities of some
synergies that would result.
In order to evaluate the merits of this proposal, it is necessary to make some
preliminary calculations upon which more detailed analysis would be based. In the
following tables are extracts from the financials for the year ended 31st December 2010,
for the two companies.
Table 1: Profit and Loss Account
Sales
Operating Cost
Depreciation
Interest Expense
Multiproduct
N
5,500,000
1,000,000
3,300,000
300,000
Megabucks
N
5,000,000
2,400,000
1,000,000
250,000
Multiproduct
N
200,000
50,000
250,000
2,500,000
Megabucks
N
100,000
50,000
150,000
500,000
Multiproduct
2.1
0.4
4%
7%
10,000
30%
Megabucks
2.1
0.45
4%
7%
10,000
30%
Table 2: Change in Balance Sheet
Items (Book Values)
Change in Receivables
Change in Inventories
Change in Payables
Investment Fixed Assets
Table 3: Other Information
Debt-to-Equity(Market Value)
Asset Beta
Risk-free Rate
Market Risk Premium
Number of Stocks
Marginal Tax Rate
Assuming that revenues and cost structure will remain stable at their 2010 levels in the
future, calculate for both companies separately, the following:
6(a1) Free cash flows available to shareholders.
(3 marks)
6(a2) The equity beta and cost of equity capital using the CAPM.
(3 marks)
6(a3) Determine the current equity value for both companies separately. Assume that
the beta of debt for both companies is 0.
(4 marks)
6(b) You are charged with the task of valuing an as yet unlisted company, DEF, using the
comparative valuation approach. You assume that this approach uses industry market
multiples in relation to key financial statement figures to arrive at an indicative market
value for a company.
Your research reveals that DEF has three key industry competitors: A, B and C. The
Price to sales multiples for companies A, B and C are 2.0, 2.2 and 1.7 respectively. The
Price to book multiples for companies A, B and C are 2.5, 2.5 and 2.3 respectively.
Finally, the Price earnings multiples for companies A, B and C are 20, 18 and 17
respectively. What is the market value of DEF, if its sales are N12 million, its book value
of equity is N9 million, and its net profit is N1.5 million?
6(b1) Based on the information above, complete the table:
Basis of valuation
Market to sales
ratio
Price to book ratio
Price earnings ratio
Market value
of DEF
(3 marks)
6(b2) What are the strengths of the comparative valuation models?
(3 marks)
Question 7 – Fixed Income Valuation and Analysis
7(a) Consider the two bonds described below. Use the information for these two bonds to
answer the following questions.
Bond A:
Bond B:
10% coupon (annual)
Zero coupon bond
5 years to maturity
10 years to maturity
7(a1) Assuming the market yield on both bonds is currently 8%, calculate the prices of
these two bonds.
(4 marks)
7(a2) Again, assuming the market yield is 8%, calculate the durations of each of these
bonds.
(5 marks)
7(a3) Suppose you manage fixed income investments for the Gotto Lottery. You know that
the lottery has a commitment to pay out N1,000,000 seven years from today. Based
on your answers to parts 7(a1) and 7(a2), calculate the positions you could take
today in bonds A and B that would immunize the Lottery against interest rate risk
during the next seven years (in other words, how many of each of these two bonds
would you need to buy today to hedge your N1,000,000 liability against interest rate
risk?)
(6 marks)
7(b) At the present time you expect a decline in interest rates and must choose between
two portfolios of bonds with the following characteristics:
Average maturity
Average YTM
Modified duration
Modified convexity
Call features
Portfolio A
10.5 years
7%
5.7 years
125.18
Non callable
Portfolio B
10.0 years
10%
4.9 years
40.30
Deferred call features that
range from 1 to 3 years
Select one of the portfolios and discuss three factors that would justify your selection.
(3 marks)