This paper is not to be removed from the Examination Halls
UNIVERSITY OF LONDON
AC3143 ZB
BSc degrees and Diplomas for Graduates in Economics, Management, Finance
and the Social Sciences, the Diplomas in Economics and Social Sciences and
Access Route
Valuation and Securities Analysis
Thursday, 28 May 2015 : 10:00 to 13:00
Candidates should answer FOUR of the following TEN questions: ONE from Section A,
ONE from Section B and TWO further questions from either section. All questions carry
equal marks.
A calculator may be used when answering questions on this paper and it must comply
in all respects with the specification given with your Admission Notice. The make and
type of machine must be clearly stated on the front cover of the answer book.
PLEASE TURN OVER
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SECTION A
Answer one question and no more than two further questions from this section.
1.
Answer all parts of this question:
At the end of the financial year ending June 30, 2013, Microsystems reported common equity
of £64.9 billion on its balance sheet, with £49.0 billion invested in financial assets (in the form
of cash equivalents and short term investments) and no financing debt. For financial year
2014, the firm reported £7.4 billion in comprehensive income, of which £1.1 billion was aftertax earnings on the financial assets.
In July 2014 Microsystems distributed £34 billion of financial assets to shareholders in the
form of a special dividend.
Required:
(a)
Calculate Microsystems’ return on common equity (ROCE) for 2014.
(b)
Holding all else constant what would Microsystems’ ROCE be after the dividend payout
of £34 billion?
[6 marks]
(c)
Would you expect the dividend payout to increase or decrease earnings growth in the
future? Why?
[3 marks]
(d)
What effect would you expect the dividend payout to have on the value of a
Microsystems’ share?
[3 marks]
(e)
Explain and discuss the link between a firm’s Return on Common Equity (ROCE) and
its Return on Net Operating Assets (RNOA).
[10 marks]
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[3 marks]
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2.
The income statement and balance sheet amounts for a firm for 2012 – 2015 are
summarised below (in millions of dollars). The firm has a required return for operations of 9%
p.a.
Net financial expense
Comprehensive income
2012
£'m
1,906
1,773
133
-----133
7
126
2013
£'m
1,985
1,846
139
----139
8
131
2014
£'m
2,064
1,919
145
(45)
100
8
92
2015
£'m
2,147
1,997
150
60
210
9
201
Net operating assets
Net financial obligations
Common equity
945
150
795
983
155
828
1,022
175
847
1,063
120
943
Core operating sales
Core operating expenses
Core operating income
Unusual operating income
Required:
(a)
Calculate the following for 2013- 2015:








Return on net operating assets (RNOA)
Core return on net operating assets (Core RNOA)
Free cash flow
Net payments to common shareholders
Net payments to net debt holders
Asset turnover
Core profit margin
Growth rate for net operating assets
Use beginning-of-period balance sheet numbers in denominators.
(b)
(c)
[10 marks]
On the basis of these financial statements, forecast
i.
Abnormal operating income for 2016 and 2017.
[2 marks]
ii.
Abnormal operating income growth for 2017.
[2 marks]
Value the equity at the end of 2015 using two methods:
i.
Abnormal operating income valuation
[2 marks]
ii.
Abnormal operating income growth valuation
[2 marks]
(d)
Calculate the enterprise price-to-book ratio implied by your valuation in (c). Also,
calculate the enterprise trailing and forward P/E ratios implied by your valuation.
[4 marks]
(e)
After making your valuation you discover that the firm has 37 million employee stock
options outstanding, valued at £10 per option. The firm’s tax rate is 35%.
How does this information change your calculation of the enterprise price-to-book ratio?
[3 marks]
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3.
The following is an extract from Melodia plc’s reformulated income statement (values in
millions of pounds):
2014
£’m
14,108
Net sales
4,772
Other operating expenses
2,628
Depreciation
Net financial expense
600
The reformulated balance sheet of Melodia plc is as follows (values in millions of pounds):
Intangible assets
Property, plant and equipment
Inventory
Operating obligations
Interest-bearing debt
Called up share capital
Share premium
Retained earnings
2013
13,500
9,000
6,150
8,850
6,900
4,500
4,620
3,780
2014
16,250
13,500
9,226
13,276
10,350
6,750
5,600
3,000
Required:
(a)
Calculate the free cash flow (FCF) of Melodia plc for the year 2014.
(b)
For the year 2014, Melodia’s cost of equity is 8%, cost of debt is 6% and the tax rate is
10%. Calculate its weighted average cost of capital (WACC) for this year. Assume that
the market values of debt and equity are equal to their book values.
[4 marks]
(c)
Under the competitive equilibrium assumption the terminal value in the discounted cash
flow model is the present value of the end-of-year book value of equity in the terminal
year. Explain.
[5 marks]
(d)
Discuss the limitations of the Present Value of Discounted Free Cash Flow (PVDCF)
method.
[5 marks]
(e)
Explain why terminal values in accounting-based valuation are significantly less than
those for DCF valuation.
[5 marks]
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[6 marks]
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4.
5.
Answer all parts of this question:
(a)
Nova Medica Ltd announces £12 million rise in profits. Is its stock price going to rise?
Explain.
[10 marks]
(b)
Assume Cure Ltd is an identical company to Nova Medica Ltd. The only difference
between the two companies is that Cure Ltd capitalises its R&D investments whereas
Nova Medica Ltd expenses them. In the same period when Nova Medica Ltd
announces £12 million increase in earnings, Cure Ltd announces £18 million increase
in earnings. How will the price of Cure Ltd change relative to the price of Nova Medica
Ltd?
[8 marks]
(c)
Critically assess how accounting analysis may improve accounting-based valuations.
[7 marks]
The summarised balance sheets of Marlene Ltd are as follows (values in millions of pounds):
Net operating assets
Financial assets
Financial obligations
Common shareholders’ equity
2013
£’m
105,000
20,100
56,100
69,000
2014
£’m
123,000
22,200
63,900
81,300
In 2014 operating income is £16,800 (million) and the forecast growth rate of net operating
assets 3%.
Required:
(a)
Assuming that the weighted average cost of capital for the firm (WACC) = 9.5%, use
Forecasting from Book Values (SF1 Forecasting), Forecasting from Earnings and Book
Values (SF2 Forecasting) and Forecasting from Accounting Rates of Return (SF3
Forecasting) to estimate the value of Net Operating Assets (NOA) in the year 2014.
Critically discuss your results.
[5 marks]
(b)
Explain under which conditions the 3 methods in (a) would be applicable for estimating
NOA.
[8 marks]
(c)
How does simple forecasting differ from full forecasting?
(d)
What is the difference between SF1 and SF2 forecasts? What is the difference between
SF2 and SF3 forecasts?
[8 marks]
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[4 marks]
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6.
Answer all parts of this question:
(a)
What are the critical drivers of industry profitability?
(b)
Fred argues: “The standards that I like most are the ones that eliminate all management
discretion in reporting—that way I get uniform numbers across all companies and don’t
have to worry about doing accounting analysis.” Do you agree? Why or why not?
[7 marks]
(c)
Which of the following types of firms do you expect to have particularly high or low
asset turnover? Explain why.
a. Supermarket
b. Pharmaceutical company
c. Jewellery retailer
d. Software company
[10 marks]
[8 marks]
SECTION B
Answer one question and no more than two further questions from this section.
7.
8.
Answer both parts of this question:
(a)
How can one exploit mispricing in the capital markets in the context of IPOs?
[12 marks]
(b)
How do glamour stocks differ from value stocks?
[13 marks]
Answer both parts of this question:
(a)
What are the characteristics of Internet stocks that influence their valuation? Explain.
[10 marks]
(b)
Is there any difference in the relative importance of financial and non-financial
information before and after the dot.com bubble? Explain.
[15 marks]
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9.
Answer all parts of this question:
(a)
What are the main objectives of an accounting analysis?
[5 marks]
(b)
How can fundamental analysts trade on the basis of an accounting analysis?
[10 marks]
(c)
What evidence is there of abnormal returns to an accounting analysis?
[10 marks]
10. Answer all parts of this question:
(a)
How does knowledge of the main determinants of price-to-book (PB) ratios in efficient
markets help you to explain the following evidence, reported from Penman’s large
sample study?
Abnormal earnings in post-horizon years
Year relative to current year (Year 0)
PB ratio level PB ratio
0
1
2
3
4
High
6.7
0.18
0.23
0.22
0.22
0.23
Medium
1.4
0.03
0.03
0.03
0.04
0.05
Low
0.4
-0.09
-0.07 -0.07 -0.04
-0.02
5
0.24
0.03
-0.04
[10 marks]
(b)
How do contrarian strategists interpret high and low PB and price-to-earnings (PE)
ratios?
[7 marks]
(c) Why are price-to-earnings (PE) ratios more volatile than price-to-book (PB) ratios?
[8 marks]
END OF PAPER
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