CIS September 2012 Exam Diet. Examination Paper 2.2: Corporate Finance Equity Valuation and Analysis Fixed Income Valuation and Analysis

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1 CIS September 2012 Exam Diet Examination Paper 2.2: Corporate Finance Equity Valuation and Analysis Fixed Income Valuation and Analysis

2 Corporate Finance (1 13) 1. Assume a firm issues N1 billion in debt to repurchase shares. We would expect the firm s beta to: A. Increase. B. Stay the same. C. Decrease. D. None of the above. 2. Which of the following statements concerning the principles underlying the capital budgeting process is correct? A. Cash flows are analyzed on a pre-tax basis. B. Financing costs should be added to the required rate of return on the project. C. Cash flows should be based on opportunity costs. D. The net income for a project is essential for making a correct capital budgeting decision. 3. An analyst gathered the following data about a company: Capital structure Required rate of return 50% debt 10% for debt 20% preferred stock 12% for preferred stock 30% ordinary shares 16% for ordinary shares Assuming a 30% tax rate, what after-tax rate of return must the company earn on its investments? A. 10.7% B. 12.2% C. 14.2% D. 18.0% 4. X Plc is an oil company with debt of N4,000,000 and equity of N10,000,000. Shares in X Plc have a beta of 1.8. Assuming the applicable company income tax rate is 30%, what is the ungeared beta of X Plc shares? A B C D Which of the following statements is wrong about Modigliani-Miller proposition I? A. This proposition is based on the efficient market hypothesis. B. The value of a company doesn t depend on the capital structure. C. The cost of capital of a company doesn t depend on the capital structure. D. Leverage affects shareholders wealth. 6. Which of the following is correct with regard to the graph below? Net Present value 0 5% 10% 15% Interest rate

3 I. The IRR is 10% II. The NPV at 15% is positive. III. As discount rates fall, project NPV rises. A. I and II only. B. I and III only. C. II and III only. D. All of the above. 7. There are various theories concerning the dividend policy of companies. Which of the following statements is wrong? A. Dividend policy irrelevance means that investors prefer capital gains to dividends. B. Dividends are irrelevant only in a perfect world without taxes and transaction costs. C. Individuals in high tax brackets might prefer capital gains to dividends. D. Individuals in low tax brackets might prefer dividends to capital gains. 8. Which of the following statements is wrong? A. The beta of a risk free-security is zero. B. The expected return of a risk-free security is zero. C. Beta is an index measure of systematic risk. D. The expected return of a risky security can be lower than the risk-free return. 9. Probability 20% 30% 20% 20% 10% NPV N100 - N50 N0 N125 N200 Knowing that the required rate of return for a project of comparable risk is 12%, would you invest in this project? A. Yes. B. No. C. I m neutral whether the project is accepted or not. D. It is not possible to decide based on the information given. 10. Given the following information from the financial statements of JFK Limited: Profit before interest and tax N750,000 Depreciation N125,000 Taxes 30% Increase in new investments N250,000 Reduction in working capital N150,000 What is the free cash flow to equity? A. N150,000 B. N250,000 C. N550,000 D. N650, Which of the following statements is (are) true with respect to business risk? I. As the variable cost structure of a company increases, so will its degree of business risk. II. Business risk will increase the volatility of earnings relative to the volatility of sales. III. As the debt structure of a company increases, so will its business risk. IV. During booming economic times, it is more logical to invest in companies with greater degree of business risk. A. I, II, and III only. B. I and III only. C. I, II, and IV only. D. II and IV only.

4 12. ABC Co. is expecting its earnings to be N25 million for this current year. Its stated dividend payout rate is 40%. There are 10 million shares outstanding, each trading at N22. If, instead of paying dividends, the company decides to use that same amount to repurchase its shares at N24, what will be the expected market price after the repurchases have been completed? (Assume that the P/E ratio for ABC will remain constant throughout this period). A. N23.10 B. N23.78 C. N22.80 D. N Zuma Limited can reinvest net income to earn 22% per year. What will be Zuma s long term dividend growth rate if the company constantly pays out 35% earnings as dividends? A. 7.7% B. 13.5% C. 14.3% D. 62.9% Equity Valuation and Analysis (14 26) 14. Which of the following is false regarding the differences between debt and common stock? A. Equity is ownership in a firm but debt is not. B. Stockholders have voting power while creditors usually do not. C. Periodic payments made to either class of security are tax deductible for the issuer. D. Interest payments are legally binding while dividend payments generally are not. 15. TPA Limited has just paid dividends of N3 per share. The earnings per share for the company was N4. If you believe that the appropriate discount rate is 15%, and the long term growth rate is 6%, then the firm s P/E ratio is: A B C D What should be the proper course of action for a company whose return on equity is greater than the return required from its stockholders? A. The company should reduce its dividends and plow more of its earnings back into its operation. B. The company should increase its dividends now that its profits are growing at a faster rate. C. The company should maintain the same level of dividends. D. Dividend policy is irrelevant when it comes to this matter. 17. XYZ Corporation has an outstanding preferred stock with a stated dividend of N2.25. The nominal risk-free rate of return is 5%, while the current inflation premium is 2%. If the credit spread on this issue is 3%, what should the current stock price of these preferred shares be? A. N28.13 B. N22.50 C. N75.00 D. N80

5 18. Which of the following statements incorrectly describes how structural changes may affect industries? I. Improvements in technology will benefit all industries in an economy. II. A change in lifestyle is largely independent of economic cycles. III. Structural changes have a much longer lasting impact on industries than would cyclical changes. A. I only. B. II only. C. I and II only. D. II and III only. 19. Which of the following statements correctly define Market Value Added (MVA)? It is A. Net operating profit after taxes less capital charge. B. Free cash flow to the firm adjusted for abnormal earnings. C. The present value of all future economic value added (EVAs). D. Free cash flow to equity. Use the information below to answer questions 20 and 21: Riverside Limited's last dividend was N1.55 and the directors expect to maintain the historic 5 percent annual rate of growth. You plan to purchase the stock today because you feel that the growth rate will increase to 8 percent for the next three years and the stock will then reach N22.50 per share. 20. How much should you be willing to pay for the stock if you require a 15 percent return? A. N16.97 B. N18.90 C. N21.32 D. N How much should you be willing to pay for the stock if you feel that the 8 percent growth rate can be maintained indefinitely and you require a 15 percent return? A. N18.90 B. N19.28 C. N22.14 D. N Preferred stock is much like debt in that: I. The payments on both are tax-deductible to the issuing firm. II. Neither security is protected in the event of non-payment of promised cash flows. III. Neither security participates in any unexpected profits the firm generates. A. I only. B. II only. C. III only. D. I and III only. 23. The current price of XYZ stock is N Dividends are expected to grow at 5% indefinitely and the most recent dividend was N2.75. What is the required rate of return on XYZ stock? A. 7.3% B. 8.6% C. 9.5% D. 10.6%

6 24. You own 500 shares of FBN Plc, with a current market price of N60 per share. FBN Plc received shareholder approval to split its stock under a 3-for-2 stock split. How many shares do you now have and at what price? A. 750 shares at N60 per share. B. 1,500 shares at N30 per share. C. 750 shares at N40 per share. D. 1,500 shares at N20 per share. 25. For which of the following types of companies would the use of constant growth dividend discount model be most appropriate? A. A well-established company that operates in an industry that only has a few participants, and all participants enjoy a moderate growth rate. B. A new company that has a promising product that is expected to generate a very high growth rate over the next few years. C. A company which has a constant earnings growth rate, however, management has indicated that they rather be bought out than to pay any dividends. D. A company at the decline stage of the industry life-cycle. 26. The accounts of Intermobile Limited for the three month period to 31 December 2011 show a profit after tax of N726,580. The managing director wishes to assess performance using Economic Value Added. The finance director has provided the following data: Value of assets employed: Net book value N4,759,600 Economic value N5,200,000 Cost of capital: 11% per annum. What is the EVA for the three month period to 31 December 2011? A. N154,580 B. N203,024 C. N583,580 D. N595,691 Fixed Income Valuation and Analysis (27 40) 27. A 10-year, 7.75% coupon, semi-annual payment bond with required return equal to 9% will: A. Be priced at par value. B. Be priced at a premium to par value. C. Be priced at a discount to par value. D. None of the above. 28. Based on the following spot rates: Time Annual (Years) Spot Rate % % % 4 9.0% The one-year forward rate two years from now is closest to: A. 7.0% B. 7.6% C. 10.3% D. 10.0%

7 29. John, an investor preferring income to capital gains, is considering several 10-year bonds that are all rated BBB and are quoted at the same ask price but have different provisions in their indentures. If he expects that interest rates will fall sharply over the next two years, John would most likely prefer a(n): A. Inverse floater with a nonrefundable provision. B. Floater with a cap. C. Mortgage-backed bond. D. Zero coupon bonds. 30. A bond with duration of 4.30 currently sells at N965. A 50 basis point decrease in rates would cause the bond price to change by approximately: A % B. 2.15% C. 4.30% D % 31. Which of the following would result from an increase in expected interest rate volatility? A. Increase in price of both putable and callable bonds. B. Decrease in price of both putable and callable bonds. C. Increase in price of a putable bond and a decrease in price of a callable bond. D. Need further information, especially maturity. 32. Suppose that the value of an option-free bond is equal to , the value of the corresponding callable bond is equal to 99.42, and the value of the corresponding putable bond is What is the value of the call option? A B C D A large grocery chain is re-evaluating its bonds since it is planning to issue a new bond in the current market. The firm's outstanding bond issue has 6 years remaining until maturity. The bonds were issued with a 6 percent coupon rate (paid semiannually) and a par value of N1,000. Because of increased risk the required rate has risen to 10 percent. What is the current value of these securities? A. N B. N C. N D. N An investor is thinking of investing in one of the following bonds: o Bond A is a 12 year, Baa-rated, 10% coupon, non-callable bond trading at 108; o Bond C is a 12 year, A-rated, zero-coupon, non-callable bond tradition at 50.83; o Bond D is a 25-year, 6% Treasury bond trading at par. Which of these bonds has the least interest rate risk? A. Information on holding period is needed. B. Bond A. C. Bond C. D. Bond D. 35. What is an investment-grade bond? A. A bond which does not have credit risk. B. A bond which corresponds to the investment criteria of a client. C. A bond with a rating above BB+ D. None of the above answers is correct.

8 36. Bond A has duration of and bond B has duration of An increase in required return of 25 basis points: A. Will cause a percentage increase in the price of A greater than the percentage increase in the price of B. B. Will cause a percentage increase in the price of B greater than the percentage increase in the price of A. C. Will cause a percentage decrease in the price of A larger in absolute value than the percentage decrease in the price of B. D. Will cause a percentage decrease in the price of B larger in absolute value than the percentage decrease in the price of A. 37. 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 low interest rate environment. C. A bond that has a low convexity should always be preferred to a bond that has a high convexity. D. None of the above. 38. A 10-year, 8% coupon convertible bond is currently trading at N The conversion price of the bond is N The underlying common stock of the same issuer is currently paying a dividend of N1.65 and is priced at N 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. 39. Contingent immunization: I. Is a mixed-active passive bond portfolio management strategy. II. Is a strategy whereby the portfolio may or may not be immunized III. Is a strategy whereby if and when some trigger point value of the portfolio is reached, the portfolio is immunized to insure an minimum required return. A. I only. B. I and II only. C. II and III only. D. All of the above. 40. Which of the following statements is (are) valid regarding the interest rate risk for floating rate securities? The price of a floating-rate security will fluctuate because: I. The longer the time to the next coupon reset date, the greater the potential price fluctuation. II. The required margin that investors demand in the market changes. III. A floating-rate security will typically have a cap. A. I only. B. I and II only. C. II and III only. D. All of the above. Total = 40 marks

9 Question 2 Corporate Finance What is Management Buyout? State four (4) advantages. (3 marks) Question 3 Equity Valuation and Analysis Identify and briefly discuss three major pitfalls of the comparative valuation models for equities. (3 marks) Question 4 Fixed Income Valuation and Analysis "Buy government bonds. You cannot lose money. They are guaranteed by the government." Do you agree? Briefly discuss. (4 marks) Question 5 Corporate Finance An analyst has forecast the free cash flows of Zebra Limited for the period 2012 to 2016 below. Zebra Limited plans to maintain its capital structure as at the end of 2011 well into the future. Forecast free cash flow for 2012 to 2016 (unit: 1 million Naira) Fiscal year (Actual) Free cash-flows ,012 1,073 1,137 5(a) Assume that the equity beta of Zebra Limited is 1.2, market risk premium is 5% and cost of debt of Zebra Limited is 4%, which is equivalent to the current long-term government bond yield as a proxy for the risk free rate. Calculate Zebra Limited's weighted average cost of capital (WACC), assuming that at the end of 2011 Zebra Limited's market value of equity is N10 billion, total interest-bearing debt N10 billion and company income tax rate 30%. (4 marks) 5(b) Assume that after 2016 Zebra Limited's free cash-flows will experience constant growth at 3%. 5b1) Calculate the present value of free cash flows for the next 5 years (2012 to 2016). (2 marks) 5b2) Calculate the terminal value at the end of (2 marks) 5b3) Calculate the enterprise value of Zebra Limited at the end of (2 marks) 5(c) Assume that instead of maintaining the capital structure as at the end of 2011 into the future, Zebra Limited decided instead to change the capital structure, and have a debt/equity ratio of 0.5 Compute the new equity beta and give a brief explanation for the change in equity beta. (6 marks) Question 6 Equity Valuation and Analysis 6(a) Tigerlinks Plc is considering a bid for Newday Plc. Both companies are listed on the stock market and operate in the same business sector. Financial information on Newday Plc, which is shortly to pay its annual dividend, is as follows: Number of ordinary shares Ordinary share price (ex div basis) 5 million N33

10 Earnings per share N4 Proposed payout ratio 60% Dividend per share one year ago N2.30 Dividend per share two years ago N2.00 Equity beta 1 4 Other relevant financial information: Average sector price/earnings ratio 10 Risk-free rate of return 4 6% Return on the market 10 6% Required: 6a1) Calculate the value of Newday Plc using the Price/earnings ratio method. (4 marks) 6a2) Calculate the value of Newday Plc using the dividend growth model (where g= historical geometric dividend growth rate). (6 marks) 6(b) Discuss the significance, to Tigerlinks Plc, of the values you have calculated, in comparison to the current market value of Newday Plc. (6 marks) Question 7 Fixed Income Valuation and Analysis On 30 th June, 2010 a portfolio manager bought for N1 million (nominal) a bond of a major company in Nigeria with the following characteristics: price 98, coupon 4.5% paid on an annual basis with the 30/360 convention, the bond will be repaid at 100 on 30 th June, (a) What was the total cost that the portfolio manager paid for N1 million nominal? (2 marks) 7(b) Compute the yield to maturity of this bond (YTM) on the day the portfolio manager bought the bond. (4 marks) 7(c) In the first year during which the portfolio manager owned the bond, an accumulation of negative news concerning the company was published. On 30 th June, 2011 the CEO of the company resigned unexpectedly creating a panic sell in the market. The YTM of the bond suddenly jumped to 14%. How can you explain such a sudden jump? Is there any relationship with the term structure of interest rates? Justify your answer. (3 marks) 7(d) Compute the new theoretical price of the bond on 30 th June, (3 marks) 7(e) Two months later, on 31 st August, 2011 the portfolio manager thought that the bond was too risky for his portfolio and decided to sell it. At that time the bid-ask price of the bond on the market was Which price will you apply for the sell? Why? (2 marks) 7(f) Coupon Price YTM Macaulay s Duration (in years) Bond A 5.25% 98.54% 2.50% 2 Bond B 5.50% % 2.70% 3 The modified duration of the bond sold was The portfolio manager wants to keep the same modified duration and therefore decides to reinvest the cash of the sale into two Federal Government bonds (A and B). What percentage of each bond will the portfolio manager have to invest in order to get a modified duration of 2.34? (4 marks)

11 END OF PAPER Levered/unlevered beta: FORMULAE Annuities: Yield to maturity of a bond: Valuation of perpetual bonds: Price change approximated with duration: Portfolio duration: Macaulay duration:

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