CHARTERED INSTITUTE OF
STOCKBROKERS
ANSWERS
Examination Paper 1.2
Corporate Finance
Equity Valuation and Analysis
Fixed Income Valuation and Analysis
Professional Examination
September 2010
Level 1
1
SECTION A: MULTI CHOICE QUESTIONS
B
B
C
A
D
A
A
B
B
D
D
A
A
A
D
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
A
D
C
C
A
D
A
A
B
C
A
B
D
A
A
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
C
A
B
D
C
D
B
A
C
D
C
C
A
B
D
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
D
A
B
A
A
A
A
A
B
C
B
C
B
C
D
(60 marks)
SECTION B: SHORT ANSWER QUESTIONS
Question 2 - Corporate Finance
2(a)
i.
ii.
iii.
iv.
v.
vi.
remuneration linked to minimum profit level
remuneration linked to economic value added (EVA)
remuneration linked to turnover growth
executive share option scheme(ESOP)
compliance with requirements of corporate governance codes
compliance with stock exchange listing requirements and other regulations
½ mark for each point
(Maximum 2 marks)
2(b) Modigliani and Miller’s theory on capital structure when there is taxation
concludes that gearing up the capital structure reduces WACC and increases the
market value of a company. It suggests that the optimal capital structure is
99.9% gearing.
(1 mark)
2
Question 3 – Equity Valuation and Analysis
3(a)
i.
ii.
iii.
iv.
Increasing
Increasing
Increasing
Increasing
rate of earnings retention (or conversely reducing payout ratio).
return on equity.
gearing (which increases ROE if market conditions are favorable).
volume of business while reducing cost (this also raises ROE).
½ mark for each point
(Maximum 1 mark)
3(b)
i.
ii.
iii.
iv.
v.
Book values are subject to accounting policies (which are not uniform); this
makes intercompany comparisons difficult.
Book values could easily be manipulated.
There is usually little correlation between book values of assets and the
earnings generating capacity of a business. Meanwhile earnings / cash
generating capacity is the key issue in valuation.
Book values neglect inflation.
Book value of assets is a function of the industry/business. For instance, a
consulting firm requires few physical assets compared to a manufacturing
company.
½ mark for each point
(Maximum 2 marks)
3(c)
i.
ii.
iii.
iv.
v.
Privatization deepens the capital market by increasing the number of
securities available for trading.
Enhances transparency and accountability.
Enhances efficiency of operations.
Assists in poverty alleviation through wealth creation for shareholders.
Creates a sense of belonging to the community
½ mark for each point
(Maximum 1 mark)
Question 4 – Fixed Income Valuation and Analysis
4(a) Yield to worst is the lowest potential yield that can be received on a bond without
the issuer actually defaulting.
This metric is used to evaluate the worst-case scenario for yield to help investors
manage risks and ensure that specific income requirements will still be met even
in the worst scenarios.
(1 mark)
3
4(b)
i.
ii.
iii.
iv.
Investors education.
Deepening the secondary market and trading platform for bonds.
Creation of more bond-focused funds.
Encouraging more companies to access funds through the bond market.
½ mark for each point
(Maximum 2 mark)
SECTION C: COMPLUSORY QUESTIONS
Question 5 - Corporate Finance
a)
Computation of NPV
Year
Item
0
1
2
3
4
5
6
Machine
Profit
Depreciation
240,000
240,000
240,000
240,000
240,000
100,000
100,000
100,000
100,000
100,000
Tax
on
profit@
30%
(72,000)
(72,000)
(72,000)
(72,000)
(72,000)
Cash flow
D/F
@10%
Present
Value
(500,000)
340,000
268,000
268,000
268,000
268,000
(72,000)
1
0.909
0.826
0.751
0.683
0.621
0.564
(500,000)
309,060
221,368
201,268
183,044
166,428
(40,608)
NPV
540,560
The project has a positive NPV. Therefore the company should go ahead.
(7 marks)
Workings / Notes
i.
ii.
iii.
iv.
v.
Annual profit = 1.2 million units x 20k = N240, 000.
Depreciation charge against profit = N500, 000/ 5 = N100, 000 per annum.
NPV is computed using cash flows not accounting profit. Hence, depreciation is added
to profit to give relevant cash flow.
Tax is on profit annually = N240, 000 X 30% = N72, 000; with a year time lag for
payment.
Discount factor is 10%.
4
b) Computation of payback period
Year
Cash flow
0
1
2
(500,000)
340,000
268,000
Cumulative Cash
flow
(500,000)
(160,000)
108,000
PBP = 1 year + 160,000 x 12 months
268,000
= 1 year, 7 months
(3 marks)
Question 6 - Equity Valuation and Analysis
a1) Dividend for next year
D1 = DO ( 1 + g) = N1.50 ( 1 + 0.05) = N1.575
(1 mark)
a2) What is Flamingo’s required rate of return based on CAPM?
KE
= Rf + (Rm – Rf) B
= 4.5% + (6%) 0.85
= 4.5% + 5.1% = 9.6%
(1½ marks)
a3)
MV = DO ( 1 + g) =
KE - g
N1.50 ( 1 + 0.05) = N1.58
0.096 – 0.05
0.046
= N34.24
(2 marks)
a4)
We are required to find the appropriate growth rate ,g, which will make the
Dividend discount model estimate of market price equal N50.
Substituting for other parameters, find g in the following equation:
MV = DO ( 1 + g)
KE - g
N50 =
N1.50 (1 + g)
0.096 - g
g = 51.5/3.3 = 0.06408
= 4.408%
(3 marks)
5
b) There is no valuation model that is ‘perfect’. All available models have their
weaknesses and strengths.
The strength of dividend discount model (DDM) lies in the fact that it is based on
the general concept of value in finance. That is, the value of an asset is simply
the present value of all streams of cash flow derivable from it.
However it is true that the DDM has some weaknesses. Basically these are on
account of the simplifying assumptions underlying the model, and the difficulty of
getting accurate estimates of the parameters in the model:
i.
ii.
iii.
iv.
The assumption of no growth or constant growth of dividend in perpetuity
is unrealistic.
It is difficult to estimate the rate of return required by investors. Moreover,
the rate is not constant.
The model is not suitable for a company that has not been paying no
dividend.
The model would fail to deliver an estimate of market value anytime rate of
growth (g) exceeds required rate of return (KE)
1 mark for the strength of DDM
½ mark for each weakness
(Maximum 2½ marks)
Question 7 - Fixed Income Valuation and Analysis
a1)
i.
Current yield = Annual coupon
= 7% x N1,000
Current market price
N 960
= 7.29%
(½ mark)
ii. Yield to maturity (to the nearest whole percentage)
This is the IRR of the bond
Year
0
1
2
3
4
C/ Flow
-960
70
70
70
70
D/ F @ 5%
1
0.952
0.907
0.864
0.823
PV
-960
66.64
63.49
60.48
57.61
D/F @ 10%
1
0.909
0.826
0.751
0.683
PV
-960
63.63
57.82
52.57
47.81
5
1,070
0.784
838.88
127.1
0.621
664.47
-73.7
IRR = 5% + 127.1 (10% - 5%)
200.8
= 8.16%
(2 marks)
6
iii. More information is required to compute the horizon yield (total return).
This includes :
 Expected holding period
 Expected future selling price at the end of the holding period
(1 mark)
a2) Shortcoming of yield-to-maturity and horizon yield (1 each required).
Yield to maturity assumes that:
1. The bond is held to maturity
2. All interim cash flows are reinvested at the computed YTM
Horizon yield requires some estimates:
1. Expected holding period
2. Expected future selling price at the end of the holding period
(1 mark)
b1) Portfolio duration is the weighted average of the duration of all the bonds
making up the portfolio
Bond
W
X
Y
Z
Total
Market Value
N13 million
N27 million
N60 million
N40 million
N140 million
Duration
2
7
8
14
Duration= 13/140 x 2 + 27/140 x 7 + 60/140 x 8 + 40/140 x 14
= 0.1857 + 1.35 + 3.4286 + 4.0 = 8.9643
(1½ marks)
b2) Portfolio duration is the approximate percentage change in portfolio value
for a 100 basis point change in yield.
A 50-basis point change in yield would therefore produce a change in
portfolio value of :
8.96436% =
2
4.48 %
(2 marks)
7
b3)
Duration is a measure of the interest rate sensitivity of a bond.
Since interest rate sensitivity is one of the major sources of risk in bond
investment and portfolio management, a good understanding of the
different measures of duration is essential to minimize risks in bond
investment while maximizing the benefits.
(2 marks)
8