CIS March 2011 Exam Diet
Examination Paper 2.2:
Corporate Finance
Equity Valuation and Analysis
Fixed Income Valuation and Analysis
Level 2
Corporate Finance (1 – 13)
1.
Which of the following statements with respect to estimating the beta of a project is
incorrect?
A. The accounting beta method estimates a proxy for a project’s return by
regressing the return on assets of a pure play company with the return on assets
of all the companies that comprise the market index.
B. The fact that a project's risk is incorporated into the risk of the company as a
whole, the company beta would serve as a good proxy for the project beta.
C. The pure play method estimates the beta of a project by using as a proxy the
beta of a company that does nothing but the activity dictated by the project in
question.
D. From a practical standpoint, the pure play method is usually more difficult to
compute than the accounting beta method.
2.
Which of the following statements are true in respect of the issuance of a dividend by
a company?
I.
II.
III.
IV.
It
It
It
It
could
could
could
could
be
be
be
be
paid
paid
paid
paid
in
in
in
in
A.
B.
C.
D.
I only
I and II only
I, II, and III only
I, II, III and IV
cash.
stock.
rights.
warrants.
3.
Which of the following statements is false with respect to the similarities and
differences that exist between warrants and convertible bonds?
A. Convertible bonds are typically issued in public markets, whereas warrants are
more common among private placements.
B. Neither the exercise of a warrant nor the conversion of a convertible bond should
have any direct impact on the assets of the firm.
C. Warrants may be sold as standalone securities, whereas the call option
embedded in a convertible bond may not.
D. From the investor's point of view, the conversion of warrants or convertible
bonds into shares may result in different tax consequences.
4.
Aba Ltd has the following capital structure:
Book Value
(N)
Market Value
(N)
Common Equity
43,000,000
55,000,000
Preferred Equity
11,000,000
11,000,000
Debt
23,000,000
28,000,000
Upon further research, you discover that the yield to maturity on Aba Ltd’s debt is
7.3% and its preferred shares, while priced at N20.00 a share, pay out constant
dividend of N1.75. Furthermore, you find out that the company employs the lower of
cost or market form of accounting. If Aba Ltd has a tax rate of 35%, and its cost of
common equity is 11.3%, what must be its weighted average cost of capital?
A. 11.32%
B. 9.04%
C. 8.64%
D. 8.23%
5.
Which of the following statements is true with respect to the consequences of a
merger?
A. If an acquiring company purchases a target company that is trading at a lower
P/E than itself, than the EPS of the combined entity will always increase.
B. The cost of an acquisition may be found by subtracting the sum of the present
values of the entities on a stand-alone basis from the present value of the
entities as a combined unit.
C. A merger diversifies the operations of the company as a whole, thus the
resulting reduction in risk will cause the stock to trade at a premium.
D. Generally, the tax consequences to the target company’s shareholders are the
same irrespective of whether the acquisition is for cash or for the shares of the
acquiring firm.
6.
PQZ Limited is considering an investment of N750 million with expected after- tax
inflows of N175 million per year for seven years. The required rate of return is 10%.
Expressed in years, what is the project’s discounted payback period?
A. 4.3 years.
B. 5.4 years
C. 5.6 years.
D. 5.9 years.
7.
Which of the following scenarios would NOT be regarded as a merger and
acquisition?
A. Purchase of patents and associated manufacturing interests from owners and
venture capital investors.
B. Registration of patents purchased from owners, and start-up of a new business
to exploit those patents.
C. On-market takeover of substantial majority stake in a listed company.
D. Negotiated share exchange, resulting in a combination of two or more
businesses, each exploiting patents registered by the other business.
8.
Which of the following statements is incorrect with respect to the various theories
that exist about dividend payout policies?
A. The bird-in-the-hand theory states that a higher dividend payout ratio would
actually maximize the value of a firm's stock.
B. The tax preference theory states that a higher dividend payout ratio would result
in minimizing the cost of equity for the firm.
C. The dividend irrelevance theory simply looks at a company's free cash flows,
dividends do not matter.
D. The all-or-nothing theory suggests that the effect a dividend policy will have on
firm value will simply depend on the specific situation.
9.
Which of the following statements is least accurate with respect to the impact debt
will have on the financial profile of a company?
A. As the proportion of debt in the capital structure increases, generally, the cost of
the equity will increase as well.
B. As the proportion of debt in the capital structure increases, generally, the cost of
the debt will increase as well.
C. As the proportion of debt in the capital structure increases, net operating profit
after tax (NOPAT) will decrease.
D. Beyond a certain level of debt, the prospects of default will begin to outweigh the
tax shield that comes with debt.
10. Which of the following statements regarding short term financing is false?
A. The short term financing policy determines the size of the investments in current
assets and their financing.
B. A flexible (conservative) policy results in a relatively high level of net working
capital.
C. An aggressive policy uses short term capital to finance part of the long term
assets.
D. A conservative policy involves a low ratio of current assets to sales.
11. Which of the following statements about net working capital is not correct?
A. In the balance sheet, net working capital is that part of current assets which is
financed with long term capital.
B. A negative net working capital implies possible liquidity problems.
C. A firm with negative net working capital can consider increasing long term debt.
D. Ceteris paribus, a firm with larger net working capital is more exposed to
fluctuations in short term interest rates than a firm with small net working
capital.
12. 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.
13. 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.
Equity Valuation and Analysis (14 – 26)
14. A portfolio manager is currently evaluating the attractiveness of ABC shares. In
particular, ABC Ltd. is expected to generate free cash flows of N1.75 in year one,
N2.50 in year two, and N3.50 in year three. If the required rate of return on this
stock is 13% and the manager strongly believes that these shares could be sold at a
multiple of 14 times the estimated free cash flow at the end of year three, what
would be a fair price for these shares today?
A. N33.96
B. N54.93
C. N39.89
D. N35.98
15. A company has a required rate of return of 15%, a dividend payout ratio of 40% and
a return on equity of 18%. If the risk-free rate of return is 7%, what should the P/E
ratio of this company be?
A. 5.0
B. 2.7
C. Non-interpretable since the ROE is greater than the required rate of return.
D. 9.5
16. Which of the following statements is (are) true with respect to the basic forces that
determine the competitiveness within an industry?
I.
Industries that require heavy initial expenditures will generally be comprised of
firms that are relatively more profitable in the long run.
II. Industries that are operating at high capacity utilization rates will tend to see a
higher degree of rivalry among the member firms.
III. Industries that tend to produce a commodity-like product will see a much higher
degree of bargaining power from its customers.
IV. Industries that enable its member firms to switch among vendors without
incurring much cost will see a much higher degree of bargaining power from its
suppliers.
A.
B.
C.
D.
II and IV only
II, III and IV only
I and III only
II only
17. Which of the following statements are true regarding shareholders’ rights as they
apply to the ownership of ordinary shares?
I.
II.
III.
IV.
They
They
They
They
have the right to receive dividends.
have the right to receive evidence of ownership of stock.
are second in line for a claim on assets in the event of liquidation.
have the right to maintain their proportionate ownership in the company.
A.
B.
C.
D.
I and II only
I, II and III only
I, II and IV only
I, II, III, and IV
18. A company that re-invests parts or all its profits rather than pays them out as
dividend is characterized by which type of security?
A. Preferred stock
B. Income stocks
C. Aggressive stock
D. Growth stock
19. Which of the following statements is (are) true with respect to the effects that
business cycles will have on various types of industries?
I. Cyclical industries are always in line with the general rate of economic growth.
II. Defensive industries do well primarily when the probability of armed conflict
increases.
III. The state of the economic cycle will have little impact on growth industries.
IV. Defensive industries are primarily in the mature phase of their life cycle.
A.
B.
C.
D.
I and II only
III and IV only
I only
I and IV only
20. Given the information below, compute the Economic Value Added of CBA Limited:
Net operating profit after tax:
Beginning book value of debt:
Beginning book value of equity:
WACC:
A.
B.
C.
D.
N100
N200
N300
11%
N45
N67
N78
N95
21. XYZ Company's current sales are N7,500,000. In the next two years, sales are
expected to grow at 6% per annum and profit margin is expected to be around 11%
by the end of the period. What will be its earnings per share at the end of the twoyear period if you expect that there will be 150,000 shares outstanding and that
investors will be requiring a rate of return of 15% at that time?
A. N6.18
B. N5.83
C. N4.67
D. N5.50
22. Which of the following is not a characteristic of an investment company?
A. It allows investors’ holdings to remain liquid.
B. It allows investors to make their own specific investment choices.
C. It allows investors to diversify their holdings, regardless of size.
D. It gives investors professional management of their holdings.
23. Which of the following analytical tools are used by technical analysts?
I.
II.
III.
IV.
Bar charts.
Moving averages.
Trading volumes.
Advance/decline indexes.
A.
B.
C.
D.
I and II only
I, II, and III only
I, II, and IV only
I, II,III and IV
24. Cash flow return on investment (CFROI) differs from economic value added in that
CFROI:
A. Uses net cash flow rather than gross cash flow.
B. Uses net investment rather than gross investment.
C. Does not include non-depreciating assets.
D. Is a rate of return rather than an absolute Naira amount.
25. Regarding the three-step valuation process (or top-down approach), the most
appropriate sequence for the steps is:
A. Industry influences, general economic influences, and company analysis.
B. Company analysis, general economic influences, and industry influences.
C. General economic influences, industry influences and company analysis.
D. Company analysis, industry influences, general economic influences.
26. Which of the following statements is (are) true with respect to what makes technical
analysis useful?
I.
Equilibrium prices are determined immediately after new information enters the
market.
II. There is a lot of psychology that drives the markets.
III. Empirical evidence suggests that price patterns do in fact exist.
IV. Technical analysis requires a great deal of subjectivity, more so than
fundamental analysis.
A.
B.
C.
D.
I, II and IV only
II, III and IV only
III and IV only
II only
Fixed Income Valuation and Analysis (27 – 40)
27. An investor is currently examining the following Treasury data:
Maturity
Coupon Rate
Price
Yield-to-Maturity
6 months
0
98.09
3.90%
1.0 year
0
95.74
4.40%
1.5 years
4.70%
100.00
4.70%
What is the investor's best estimate of the annualized 1.5 year spot rate?
A. 4.25%
B. 4.33%
C. 4.71%
D. 4.91%
28. A portfolio consists of 2 bonds:
Bond A
Bond B
Maturity
10 Years
7 Years
Coupon
8%
5.20%
Duration
6.7
3.9
Proportion in Portfolio
60%
40%
Which of the following is the best measure of portfolio duration?
A. 5.30
B. 5.58
C. 3.71
D. 8.50
29. Which of the following statements is (are) true with respect to the shifts that are
observed in the yield curve?
I.
When there is a parallel shift in the yield curve, all Treasury bond prices change
by the same percentage amount.
II. Changes in the level of interest rates by far account for the majority of the
volatility in returns of Treasury securities.
III. When a yield curve undertakes a positive butterfly shift, it becomes more flat.
IV. When there is a parallel shift in the yield curve, the slope of the yield curve will
remain constant.
A.
B.
C.
D.
II only
II, III, and IV only
I and III only
I and II only
30. 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
31. Which of the following statements is least accurate with respect to the price volatility
characteristics for callable bonds?
A. The price of a callable bond can never become higher than the price of an
equivalent non-callable bond.
B. The yield on a non-callable bond can never become higher than the yield of an
equivalent callable bond.
C. At yield levels below that of the coupon rate, callable bonds become extremely
sensitive to small changes in yield.
D. For high levels of yield, the price volatility characteristics of a callable bond will
mirror that of an equivalent non-callable bond.
32. Which of the following statements is (are) true with respect to measuring interest
rate risk?
I.
The full valuation approach would require that new bond prices be calculated
whenever there is an interest rate change.
II. Duration captures the interest rate risk that can arise from any shift in the yield
curve.
III. Holding everything else constant, the duration of a bond will be higher at lower
level of interest rates than it would be at higher levels of interest rates.
IV. All callable bonds have a positive convexity.
A.
B.
C.
D.
II, III, and IV only
I and III only
IV only
I, II, and IV only
33. A 10-year, 8% coupon convertible bond is currently trading at 97.50. The
conversion price of the bond is 57.14. The underlying common stock of the same
issuer is currently paying a dividend of N1.65 and is priced at 48.95. Which of the
following would best estimate the market conversion premium per share of this
bond?
A. N8.19 per share.
B. N6.76 per share.
C. N5.13 per share.
D. N5.42 per share.
34. You wish to purchase a 15-year bond today that is trading at par. This bond pays an
annual coupon of 6% and you expect to sell it in five years when you believe the
yields on similar risk bonds will be 7%. If the reinvestment rate during this period
averages out to be 6.5%, how much will your proceeds be when you eventually sell
the bond?
A. N908.92
B. N867.59
C. N929.76
D. N964.06
35. Which of the following statements is least accurate with respect to the risks faced by
an investor who purchases a foreign currency denominated bond?
A. If the foreign currency appreciates, the return from the bond will be positively
impacted.
B. If the home currency depreciates, the return from the bond will be positively
impacted.
C. The foreign exchange risk will have a bigger impact on the face value payments
as opposed to the individual coupon payments.
D. The variability of the current spot rate makes the purchase price of the bond
difficult to determine.
36. 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
37. Which of the following spread measures would be most useful when analyzing a
mortgage-backed security?
A. Cash flow yield spread.
B. Nominal spread.
C. Option-adjusted spread.
D. Relative spread.
38. Which of the following statements is false regarding bond immunization?
A. Immunization means that investor has to sell a part or the whole of the portfolio
and buy other securities so that the duration of the new portfolio coincides with
the investor’s investment horizon.
B. This is the strategy of matching the bond‘s duration with the time horizon of the
investor.
C. Investors can protect themselves from the interest rate risk through bond
immunization.
D. Immunization will provide a compound rate of return over the period immunized
that equals the bond‘s YTM, irrespective of changes in market rates.
39. Under what circumstances would a high-convexity bond be preferred to a low
convexity bond?
A. When the economy is in a recession.
B. In a high interest rate environment.
C. In a low interest rate environment.
D. A bond that has a low convexity should always be preferred to a bond that has a
high convexity.
40. If the market rate of interest is greater than the coupon rate, the bond will be
valued:
A. Less than par.
B. At par.
C. Greater than par.
D. Cannot be determined.
Total = 40 marks
Question 2 – Corporate Finance
Outline the steps involved in using the CAPM model to derive project-specific discount
rates in situations where WACC is considered inappropriate for discounting project cash
flows.
(3 marks)
Question 3 – Equity Valuation and Analysis
3(a) Briefly explain the concept of Market Value Added for equity valuation.
(2 marks)
3(b) List two critical factors that would determine the success of an ‘Initial public offer’
(IPO).
(1 mark)
Question 4 – Fixed Income Valuation and Analysis
4(a) What do you understand by mortgage-pass-through securities?
(2 marks)
4(b) Explain cash flow matching strategy in fixed income risk management.
(2 marks)
Question 5 – Corporate Finance
You are currently conducting an analysis of the financial situation of Integrity Plc, a
company quoted on the Nigerian Stock Exchange. The company has 2,000 shares
outstanding with a book value of N25 per share, as well as 1,000 10% coupon bonds each
with a par value of N100.
You have the following additional information:
Current share price
Current market value of the bonds
Expected dividend for next year
Expected dividend growth rate
N250
N100
N50 per share
5%
It is expected that the market would evaluate equity according to a constant growth
model.
Required
5(a) Compute the company’s debt/equity-ratio and the market value of its assets.
(2 marks)
5(b) Calculate the company’s Weighted Average Cost of Capital (WACC) under the
following conditions:
5(b1) In a world without taxes.
(4 marks)
5(b2) Assuming a tax rate of 30% is applicable.
(2 marks)
5(c) If the company’s debt/equity ratio rises, how does the WACC change in a world
without taxes and in a world with taxes? (No calculations required).
(3 marks)
5(d) Suppose that the risk-free rate is 10%, and that the expected market return is 18%
per annum, what is the beta of Integrity Plc shares? What would the beta of the
company’s shares be if the company was entirely equity financed? Assume 30% tax
rate?
(5 marks)
Question 6 – Equity Valuation and Analysis
You are preparing a valuation report on Rainbow International limited, and have decided to
use the Free Cash Flow model. Available information shows that the company’s capital
structure consists of Long term debt of N215 million, at an interest cost of 7%. Debt to
total capital ratio is 30%, and this structure is expected to be maintained in future.
The company’s currently free cash flow from operations is N24 million and this is expected
to grow 21% over the next two years, 17% in the third year, and thereafter, grow at a
constant rate of 3%.
Rainbow’s International is a relatively low-risk business with a beta of 0.92. Applicable risk
free rate in the market is 3%, while market risk premium is estimated at 6%. The
company has 5 million ordinary shares outstanding, and tax rate is 40%.
Required:
6(a) Compute the weighted Average Cost of Capital of Rainbow International Limited.
(4 marks)
6(b) Forecast future periods free cash flow.
(4 marks)
6(c) Compute the present value of all future cash flows.
(Note: use WACC of 10%, if you could not solve 6(a) above).
(4 marks)
6(d) Compute value per share.
(4 marks)
Question 7 – Fixed Income Valuation and Analysis
You are seriously considering moving a large portion of your investment into bonds in
view of the downturn in the stock market. Currently you wish to limit your options to
the following bonds recommended by a colleague:
Bond
X
Y
Z
Maturity
2 years
3 years
5 years
Coupon
8%
9%
0%
Yield to Maturity
7.842%
8.027%
5.50%
7(a) Determine the price of bond X, if the following spot rates are applicable:
One year spot rate – 7.65%
Two year spot rate – 7.85%
Three year spot rate – 8.05%
(3 marks)
7(b) Given that the duration of bond Y is 2.76 years and its price is 102.51, estimate,
using the concept of duration, the expected change in the price of bond Y for a
0.2% change in yield to maturity. Is there any weakness in using this approach to
estimate expected future change in price?
(5 marks)
7(c) In your discussion with your colleague on the above referenced bonds, he raised a
number of interesting issues in respect of Bond Z.
7(c1) What type of bond is Bond Z?
(2 marks)
7(c2) From interest rate risk management perspective, what attractive attribute
does bond Z have?
(3 marks)
7(d) In your further study of fixed income investing, you just read an article that
concludes that ‘‘credit spread widens when the economy is facing a downturn, but
contracts as the economy recovers’’.
7(d1) What is credit spread?
(2 marks)
7(d2) Explain the behaviour of credit spread as summarized in 7(d) above.
(3 marks)
FORMULAE
1)
2)
3)
Levered/unlevered beta:
Annuities:
Yield to maturity of a bond:
4)
Valuation of perpetual bonds:
5)
Price change approximated with duration:
6)
Portfolio duration: