CHARTERED INSTITUTE OF
STOCKBROKERS
ANSWERS
Examination Paper 2.2
Corporate Finance
Equity Valuation and Analysis
Fixed Income Valuation and Analysis
Professional Examination
September 2010
Level 2
1
SECTION A: MULTI CHOICE QUESTIONS
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
D
C
C
C
D
A
B
C
C
C
C
A
D
C
C
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
B
A
A
C
B
C
A
D
C
C
A
A
C
D
B
31
32
33
34
35
36
37
38
39
40
C
C
D
A
A
A
D
D
D
D
(40 marks)
SECTION B: SHORT ANSWER QUESTIONS
Question 2 – Corporate Finance
2(a) Asset beta reflects only the business risk inherent in the operations of a firm.
Hence all the firms operating in a particular line of business would face similar
business risk hence have the same asset beta.
Equity beta however reflects both business risk and financing risk. Hence the
higher the gearing of a firm the higher the equity beta the firm would have.
(1½ marks)
2(b)
i. With tax, the company’s WACC would fall.
ii. With tax, the overall value of the company would rise due to the tax shield of
debt capital.
iii. The company would face higher bankruptcy risk as gearing increases.
iv. The company’s EPS and ROE would rise faster if ROCE exceeds cost of debt.
v. The cost of equity capital (KE) would rise all other things being equal as equity
shareholders demand higher returns for the greater risk.
½ mark per point (Maximum 1½ marks)
2
Question 3 – Equity Valuation and Analysis
3(a) Weaknesses of the free cash flow model:
i. It requires a lot of forecasting, and is therefore susceptible to estimation error.
ii. It assumes constant rate of growth (or no growth as the case may be) after the
explicit forecast period, which is unrealistic in real life.
iii. The model is particularly sensitive to estimated rate of growth, and a slight
deviation from the true rate would give misleading result.
(1½ marks)
3(b)
i. Management depth and experience.
ii. The caliber, motivation, integrity, dynamism, and commitment of the top
management personnel.
iii. The execution ability of management.
iv. The specific objectives, plans and time-bound programmes set by management.
v. Track record, transparency and accountability.
vi. Effectiveness of the organizational structure.
vii. Soundness of the management systems.
viii. Importance assigned to management development.
ix. Investor –friendliness of the management team?
x. Emphasis accorded research and development.
(1½ marks)
Question 4 – Fixed Income Valuation and Analysis
4(a) Active bond management strategies include:
i.
ii.
iii.
iv.
v.
Interest rate anticipation
Valuation analysis
Credit analysis
Yield spread analysis
Bond swaps
Any four points
½ mark per point (Maximum 2 marks)
4(b) Convexity is a desirable trait for the following reasons:
i. A bond with greater convexity is less affected by interest rates than a bond with
less convexity.
ii. A bond with greater convexity will have a higher price than a bond with a lower
convexity, regardless of whether interest rates rise or fall.
1 mark each (2 marks)
3
SECTION C: ESSAY TYPE/CALCULATIONS
Question 5 – Corporate Finance
a)
The gain from the acquisition would be the difference between value of target now and
value after the acquisition.
Current value =
N20 =
D1
KE – g
= 0.8
KE – 6%
Therefore, equity required rate of return = KE = 10%
Value of target would become
P=
0.8
10% – 8%
= N40 per share
Value of equity after acquisition = N40 X 0.6 million = N24 million.
Gain from acquisition = N24 million – N12 million = N12 million
b)
(5 marks)
Cost of the acquisition if Big Limited pays N25 in cash for each share of Small Limited:
(N25 – N20) X 0.6 million shares = N3 million
Net present value of acquisition:
= N12 million expected gain from acquisition less N3 million cost of acquisition
= N9 million.
NPV is positive; therefore the company should proceed.
c)
(3 marks)
Number of new shares required to fund the acquisition= 0.6 million/3
= 0.2 million shares
Value of the new company = N90 million + 12 million + 12 million
(1 + 0.2) million shares
= N114 million/1.2 million shares
= N 95 per share
Cost of acquisition = (0.2 million x N95 million) – N12 million = N7 million
NPV of acquisition = N12 million – N7 million = N5 million.
Advise to proceed.
(4 marks)
4
d)
i. Cost of cash bid unchanged. As there are no gains on acquisition, there is no point
proceeding.
ii. With the share exchange
Value of new company = N90 million + N12 million
1.2 million shares
NPV of acquisition (0.2 million x N85) – N12 million = - N5 million.
Advice not to proceed on this basis.
(4 marks)
Question 6 – Equity Valuation and Analysis
NOPAT = EBIT (1-T)
N
1,500
Less Net Capital expenditure (1,000- 400)
(600)
Changes in working capital
(150)
Free Cash Flow to the Firm (FCFF)
750
Book value of capital invested (5,000 + 2,500)
7,500
Reinvestment rate (600 + 150)/1,500
50%
Return on capital
20%
(1,500/7,500)
Expected growth rate, (g =r.B = 0.2x 0.5)
a)
Year
EBIT (1-T)
Net Capital Exp
Change in WC
FCFF
1
1650
(660)
(165)
825
10%
2
1825
(726)
(181.5)
907.50
3
1996.50
(798.60)
(199.65)
998.25
b) Terminal value computation
Growth rate of FCFF
= 3%
WACC
= 10%
Terminal value
= FCFF3 (1 + g)
WACC – g
= 998.25 (1.03) = 1028.1975
0.1 – 0.03
0.07
= N14, 688.54
5
c) Value of equity per share today:
Value of the firm = PV of FCFF for the next three years + PV of terminal value
(Discount rate of 12% used to determine PV)
= (828 x 0.893 + 907.5 x 0.797 + 998.25 x 0.712)
+ (14,688.54 X 0.712) =
= N2,170.56 + N10,458.24
= N12, 628.80
Value of firm = Value of debt + Value of equity
Value of equity = N12,628.80 – N2,500 = N10,128.80
Per share value = N10,128,800/ 1,000,000 Shares
= N10.1288
Approx N10.13/ share
Question 7 – Fixed Income Valuation and Analysis
7a)
Duration of bond X:
Year
Cash flow
D/F @
5.92%
PV of Cash
flow
Weight
T X Weight
1
55
0.9441
51.93
0.05
0.05
2
55
0.8913
49.02
0.05
0.10
3
55
0.8415
46.28
0.05
0.14
4
55
0.7945
43.70
0.04
0.18
5
1,055
0.7501
791.34
0.81
4.03
982.27
Duration
4.50
Bond Price
(4 marks)
7b) Time to maturity assesses bond risk from a final maturity date perspective only.
It does not take into cognizance the cash flows received prior to final maturity.
However, duration takes into consideration all the cash flows, the weight of the
cash flows as well as the impact of time value of money on cash flows in
analyzing bond risk. Hence, it is a superior matrix.
(2 marks)
6
7c)
Duration of a bond is the weighted average maturity of its cash flows, where the
weights are proportional to the present value of cash flows. A zero-coupon bond
does not have intermediate cash flows; hence its duration is always equal to its
maturity.
The duration of a coupon bond with same time to maturity has to be less than the
maturity of the bond because of the presence of intermediate cash flows.
Therefore, the duration of a coupon bearing bond cannot be greater than the
duration of a zero-coupon bond with the same maturity.
(3 marks)
7d) Modified duration for bond X:
D(modified)
=
Duration
(1 + k)
=
4.5
1 + 5.92 %
=
4.25
Modified duration signifies the risk exposure of a bond to interest rate changes.
It is used to measure the approximate change in bond price as a result of a small
change in yield.
% Change in price = - D(modified) x Change in yield
(2 marks)
7e)
Duration of a perpetual bond is given by this formula:
D = 1+ k =
k
1 + 5.92%
5.92%
= 17.89 years
(2 marks)
7f)
If the yield of bond X changes to 6%, what would be its new approximated price,
using the modified duration?
% Change in price = - D(modified) x Change in yield
= - 4.25 x (6% - 5.92%)
= -4.25 x 0.08% =
- 0.0034
This means new price = (1 - 0.0034) x current price
= 0.9966 x 982.27
= 978.93
(5 marks)
7