CHARTERED INSTITUTE OF
STOCKBROKERS
ANSWERS
Examination Paper 2.2
Corporate Finance
Equity Valuation and Analysis
Fixed Income Valuation and Analysis
Professional Examination
September 2011
Level 2
1
SECTION A: MULTI CHOICE QUESTIONS
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
C
B
D
C
A
C
C
C
B
B
C
D
D
C
D
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
C
A
A
C
C
B
B
B
A
D
B
D
C
B
B
31
32
33
34
35
36
37
38
39
40
A
D
D
A
B
A
D
B
C
D
(40 marks)
SECTION B: SHORT ANSWER QUESTIONS
Question 2 – Corporate Finance
The use of cash flow to evaluate investment projects is more consistent with the
objective of the firm, which is the maximization of shareholders’ wealth.
In other words, the higher the net cash surplus from a project, the greater the increase
in shareholders’ wealth.
Total = 3 marks
Question 3 – Equity Valuation and Analysis
There are three primary ways that analysts assess the quality and depth of a company’s
management.
i)
ii)
iii)
First, the analyst examines management’s performance record. Management
receives a positive assessment if the firm has prospered under the current
management.
Second, the analyst meets directly with management, conducting interviews and
attending presentations by managers.
Third, the analyst evaluates evidence of management’s strategic planning and
attempts to determine the ability of management to achieve its stated goals.
(1 mark each for each points)
Total = 3 marks
2
Question 4 – Fixed Income Valuation and Analysis
The price of the bond will change for one or more of the following three reasons:
i)
There is a change in the required yield that is tied to changes in the credit
quality of the issuers.
ii) There is a change in the price of the bond selling at a premium or a discount
without any change in required yields, simply because the bond is moving
toward maturity.
iii) There is a change in the required yield owing to a change in comparable bonds
(i.e. a change in the yield required by the market).
(1 ½ marks for each point)
Maximum = 4 marks
SECTION C: ESSAY TYPE/CALCULATIONS
Question 5 – Corporate Finance
5(a1)
Project 1 – Net cash flow
Cash flow
12% discount
factor
Net cash
flow
Year 0 (Initial
investment)
-300,000
1
-300,000
Year 1
85,000
0.893
75,905
Year 2
90,000
0.797
71,730
Year 3
95,000
0.712
67,640
Year 4
100,000
0.636
63,600
Year 5
95,000
0.567
53,865
NPV
32,740
(2 marks)
Project 2 – Net cash flow
Cash flow
12% discount
factor
Net cash
flow
Year 0 (Initial
investment)
-450,000
1
-450,000
Year 1
140,800
0.893
125,734
Year 2
140,800
0.797
112,218
Year 3
140,800
0.712
100,250
Year 4
140,800
0.636
89,549
Year 5
140,800
0.567
79,834
NPV
57,584
(2 marks)
3
5(a2)
Since the projects are divisible use the profitability index method to rank the projects.
Project
Profitability
Index
Ranking
Investment
3rd
0
NPV N‘000
32,740/300,000
1
= 0.109
400,000
57,584/450,000
2
= 0.128
2nd
3
77,791/400,000
=0.194
1st
(89% of
project)
400,000
400/450*
57,585=
51,187
(100% of
project)
77,791
Total NPV
128,978
(4 marks)
5(a3)
Capital rationing is a situation in which a company has a limited amount to invest in
potential projects, such that the different possible investments need to be compared
with one another in order to allocate the capital available most effectively.
If an organization is in a capital rationing situation, it will not be able to undertake all
available positive NPV projects.
There are two forms of capital rationing:
Hard capital rationing: This is brought about by external factors. For example, the
recent global economic meltdown. This makes it difficult for firms to access funds.
Hard capital rationing may arise for one of the following reasons:
i.
Raising money through the stock market may not be possible if share prices are
depressed.
ii.
There may be restriction on bank lending due to government control.
iii.
Lending institutions may consider an organization to be too risky(e.g too highly
geared, poor prospects) to be granted further loan facilities.
iv.
The costs associated with making small issues of capital may be too great
4
Soft capital rationing
This is internally imposed for various reasons:
i.
ii.
iii.
iv.
v.
Management may be reluctant to issue additional share capital because of
concern that this may lead to outsiders gaining control of the business.
Management may be unwilling to issue additional share capital if it will lead to a
dilution of earnings per share.
Management may not want to raise additional debt capital because they do not
wish to be committed to large fixed interest payments.
Management may wish to limit investment to a level that can be financed solely
from retained earnings.
They may not want to grow the company too quickly.
(4 marks)
5(b1)
80% (1.2) + 15% (1.4) + 5% (0.9) = 1.215
(2 marks)
5(b2)
Based on the asset beta of 1.1, I would advise that the company goes ahead with the
new line on business. This is because with a lower beta than the current operations
(1.205), an overall reduction in the cost of equity would result.
However, if the existing business has a rate of return above 10% then incorporating
the new venture would dilute the return on investment, and is therefore not
recommended.
(2 marks)
Question 6 – Equity Valuation and Analysis
6(a1)
Sales Operating cost Depreciation Interest expense Profit before tax Taxes @ 30% Profit after tax Add back Depreciation Operating cash flow Increase in Current Assets Increase in Current Liabs Investment in fixed assets Free Cash Flow to Equity Multiproduct
Megabucks
5,500 5,000 1,000 2,400 3,300 1,000 300
250
900
1,350
270
405
630
945
3300
3,930
2500
2500
2500
1,430
1000
1,945
1500
1500
500
1,445
(3 marks)
5
6(a2)
Computation of equity Beta = Levered Beta
Multiproduct
0.4. [1 +(1-0.3)2/1]
= 0.96
(1 mark)
Megabucks
0.45 [1 +(1-0.3)2/1] = 1.08
(1 mark)
Computation of cost of equity capital
KE = Rf + (Rm – Rf) β
Multiproduct
4% + 0.96(7%) = 10.72%
(1 marks)
Megabucks
4% +1.08(7%) = 11.56 %
(1 marks)
6(a3)
Computation of market value of equity
Assume no growth of cash flow:
Multiproduct MV = 1,430,000/0.1072 = N13,339,552.24
Megabucks MV = 1,445,000/0.1156
(2 marks)
= N12,500,000
(2 marks)
6(b1)
Market
value of
DEF
Market to sales ratio
Price to book ratio
Price earnings ratio
(2.0+2.2+1.7)/3 X
12 million =
(2.5+2.5+2.3)/3 X
9 million =
(20+18+1.7)/3 X
1.5 million =
N 23.6 million
N21.9 million
N27.5 million
(1 mark each = 3 marks)
6
6(b2)
The comparative valuation models have the following strengths:
i)
ii)
iii)
iv)
They are market-based.
Convenience - simple and easy to use.
No complicated computations and forecasting required.
Have a direct link with the Operating Statement and Statement of Financial
Position.
(Any three points for 1 mark each = 3 marks)
Total = 16 marks
Question 7 – Fixed Income Valuation and Analysis
7(a1)
The price of the 5-year 10% coupon bond is:
B5 =
100 + 100 + 100 + 100
+ 1,100
1.08 (1.08)2
(1.08)3
(1.08)4
(1.08)5
=
N1079.85
(2 marks)
The price of the 10-year zero coupon bond is:
B30 = 1000
= N463.19
10
(1.08)
(2 marks)
7(a2)
The duration of the 5-year 10% coupon bond is:
Computation of Duration
1
2
3
PV factor @
8%
4
PV of coupon
payment
= (2 X 3)
Time
Cash flow
1
5
Time weighted
PV= (1 x4)
100
0.926
92.593
92.592593
2
100
0.857
85.734
171.46776
3
100
0.794
79.383
238.14967
4
100
0.735
73.503
294.01194
5
1100
0.681
748.642
3743.2076
1,079.854
4,539.4296
Duration =4,539.4296/1,079.854 = 4.204
(4 marks)
The duration of the zero coupon bond is equal to its maturity or 10 years.
(1 mark)
7
7(a3)
You need to choose your weights in the two securities such that your portfolio
duration equals the duration of your liability or 7 years.
7 = wA (4.2035) + (1- wA)(10)
(1 mark)
or
wA =51.755% and wB =48.245%
(1 mark)
Our total investment must equal the present value of the N1 million liabilities, or:
1,000,000
(1.08)7
=
N583,490.40
(1 mark)
We therefore need to invest as follows:
N301,987.79 [(583,490.40)(.51755)] in the 5-year bonds, and
(1 mark)
N281, 502.61 [(583,490.40)(.48245)[ in the 10-year zero coupon bonds.
(1 mark)
Given these investment requirements, we need to purchase 279.66, 5-year
bonds (or N301, 987.79/N1, 079.85)
(½ mark)
and 607.75, 10-year bonds (or N281,502.61/N463.19).
(½ mark)
This position will provide us with a value of approximately N1,000,000 seven
years from today regardless of what happens to interest rates.
7(b)
You should select portfolio A for the following reasons:
i)
It has a longer duration (5.7 versus 4.9 years), thereby offering greater price
appreciation.
ii)
It has greater convexity (125.18 versus 40.30), thereby having potential for
greater price appreciation.
iii)
It is non-callable, therefore there is no call risk (and consequently re-investment
risk) when interest rates decline.
(1 mark for each point = 3 marks)
Total = 18 marks
8