CIS September 2013 Exam Diet Examination Paper 2.2: Corporate Finance Equity Valuation and Analysis Fixed Income Valuation and Analysis Level 2

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1 CIS September 2013 Exam Diet Examination Paper 2.2: Corporate Finance Equity Valuation and Analysis Fixed Income Valuation and Analysis Level 2

2 SECTION A: MULTIPLE CHOICE QUESTIONS Corporate Finance (1 13) 1. You are given the following information from the financial statements of Real flow Limited: Profit before interest and tax N750,000 Depreciation N125,000 Taxes 30% Increase in new investments N250,000 Increase in working capital N150,000 What is the free cash flow to equity? A. N150,000 B. N250,000 C. N550,000 D. N650, Stock A has an expected return of 10% per year and stock B has an expected return of 20%. If 55% of the funds are invested in stock B, what is the expected return on the portfolio of stock A and stock B? A. 10% B. 20% C. 15.5% D. None of the above. 3. A firm has N100 million in current liabilities, N200 million in total long-term liabilities and N300 million in stockholders' equity, total assets of N600 million. What is the debt ratio for the firm? A. 40% B. 20% C. 50% D. None of the above. 4. Firm A has a value of N100 million, and B has a value of N70 million. Merging the two would allow a cost savings with a present value of N20 million. Firm A purchase B for N75 million. What is the gain from this merger? A. N30 million. B. N20 million. C. N15 million. D. N10 million. 5. What are some of the possible consequences of financial distress? A. Debt holders, who face the prospect of getting only part of their money back, are likely to want the company to take additional risks. B. Equity investors would like the company to cut its dividend payment to conserve cash. C. Equity investors would like the firm to shift toward riskier line of business. D. Equity investors would like the firm to set up with creditors as fast as possible. 6. As a defensive maneuver, a firm issues bonds that make it prohibitively costly for an acquirer in the event of an unfriendly takeover. These tactics are examples of 2

3 A. Greenmail. B. A poison put. C. Crown jewels. D. White knight. 7. Consider the following statements: I. A beta factor measures the relationship between market returns and the returns of an individual security. II. A share that has a beta of 1 0 will have an expected return that moves in step with market return. Which one of the following combinations (true/false) concerning the above statements is correct? Statement I Statement II A. True True B. True False C. False True D. False False 8. When comparing geared versus ungeared capital structure, gearing works to increase EPS for high levels of generated income because A. Interest payments on the debt vary with EBIT levels. B. Interest payments on the debt stay fixed, leaving less income to be distributed over less shares. C. Interest payments on the debt stay fixed, leaving more income to be distributed over less shares. D. Interest payments on the debt stay fixed, leaving less income to be distributed over more share. 9. Which of the following comprises features from both equity and debt securities? A. Debentures. B. Mortgage-backed securities. C. Convertible notes. D. Currency swaps. 10. If the weighting of equity in total capital is 1/3, that of debt is 2/3, the return on equity is 15% that of debt is 10% and the corporate tax rate is 32%. What is the weighted average cost of capital (WACC)? A % B % C % D % 11. 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 stand alone 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. 3

4 12. ABC 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 45% earnings as dividends? A. 12.1% B. 13.5% C. 14.3% D. 62.9% 13. Which of the following factors would not tend to be associated with company having a low dividend payout ratio? A. High floatation costs on new equity issues. B. High tax rates on dividends. C. Low growth prospects. D. None of the above. Equity Valuation and Analysis (14 26) 14. The economy has just entered a state of recovery, and you would like to purchase a stock that would generate high returns in the coming months. Buying which of the following categories of stocks would most likely help you to achieve your objective? A. Cyclical stocks. B. Counter-cyclical stock. C. Defensive stocks. D. Value stocks. 15. The DRD Company has a debt equity ratio of 1.5. The cost of debt is 11% and the unlevered equity is 14%. What is the weighted average cost of capital for the firm if the tax rate is 33%? A. 7.37% B. 25.1% C % D. None of the above. 16. The current dividend yield on C. M. Limited ordinary shares is 2.5 percent. The company just paid a N1.48 annual dividend and announced plans to pay N1.54 next year. The dividend growth rate is expected to remain constant at the current level. What is the required rate of return on this stock? A percent. B percent. C percent. D percent. 17. The accounts of XYZ Limited for the year ended 31 December 2012 show a profit after tax of N2,900,000. 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: 15% per annum. What is the EVA for the year ended 31 December 2012? A. N203,024 B. N583,580 C. N2,120,000 D. N2,186,060 4

5 18. Hardy Lumber has a capital structure which includes bonds, preferred stock and common stock. Which of the following rights have most likely been granted to the preferred shareholders? I. Right to share in company profits prior to other shareholders. II. Right to elect the corporate Directors. III. Right to vote on proposed mergers. IV. Right to all residual income after the common dividends have been paid. A. I only. B. I and II only. C. I and IV only. D. II, III and IV only. 19. Although exit and entry barriers are conceptually different, their joint level is an important aspect of the analysis of an industry. Which of the following is most likely true, if entry barriers are low and exit barriers are high in the industry? A. Returns are high and stable. B. Returns are low and risky. C. Returns are high and risky. D. Returns may vary depending on industry selected. 20. J & J Foods wants to issue a 7 percent preferred stock that has a stated liquidating value of N100 a share. The company has determined that stocks with similar characteristics provide a 12.8 percent rate of return. What would be the offer price? A. N37.26 B. N41.38 C. N48.20 D. N The intrinsic value of stocks are the estimates of EPS and P/E multiple. Which of the following would you consider the best indicator of an undervalued firm? A. A firm with a P/E ratio lower than the average P/E ratio for the firm s peer group. B. A firm with a lower P/E ratio, a lower expected growth rate and lower risk than its peer group. C. A firm with a lower P/E ratio, a higher expected growth rate and higher risk than its peer group. D. A firm with a lower P/E ratio, a higher expected growth rate and lower risk than its peer group. 22. The security market indices are useful for different purposes. Which of the following statements is/are not true? A. Security market indices are the basic tools to help and analyze the movements of prices of various stocks listed in stock exchanges. B. Indices can be calculated company wise to know their trend pattern and also for comparative purposes across the industries and with the market indices. C. The investors can make their investment decisions accordingly by estimating the realized rate of return on the index between two dates. D. Funds can be allocated more rationally between stocks with knowledge of the relationship of prices of individual stocks with the movements in the market indices. 23. Business firms in their pursuit of growth, engage in a broad range of restructuring activities. Divestiture is one among them. The term divestiture involves which of the following activities? 5

6 I. Distribution of shares to the existing shareholders of the parent company. II. Sale of a portion of the firm through an equity offering to outsiders. III. Sale of a portion of the firm to an outside third party in consideration of cash or equivalent. A. I only. B. II only. C. III only. D. I and II only. 24. Reliable Investment Company is investing N100 in a project that is being depreciated straight-line to zero over a two-year life with no salvage value. The project will generate economic profit of N23 and N29 in the first and second years respectively. The company's weighted average cost of capital and required rate of return for the project are both 12% and its tax rate is 30%. What is the market value added (MVA) for the company? A B C D Which of the following is a benefit of securitization of asset-backed securities to a firm? Securitization A. Converts receivables into cash. B. Reduces the business risk of the firm. C. Removes assets from the firm s balance sheet, thus reducing the firm s exposure to interest rate risk and credit risk. D. Provides a lower cost form of obtaining funds. 26. PQR Plc is an oil company with debt of N4,000,000 and equity of N10,000,000. Shares in an equivalent all-equity financed company have a beta of Assuming the applicable company income tax rate is 30%, what is the geared beta of PQR Plc shares? A B C D Fixed Income Valuation and Analysis (27 40) 27. Which of the following statements is incorrect regarding credit default swaps? A. A CDS is in effect an insurance policy on the default risk of a corporate bond. B. CDS were designed to allow lenders to buy protection against losses on sizable loans. C. CDS are designed to transfer the credit exposure of variable income products between parties. D. The swap buyer pays an annual premium to the swap seller in exchange, receives a payoff if a credit instrument goes into default. 28. The yield curve indicates that the one, two and three-year maturity, defaultfree, zero-coupon bonds have yields-to-maturity of 5%, 6% and 8% respectively. What are the implied one-year forward rates? A. 2.0%, 6.0% B. 6.0%, 2.0% C. 7.0%, 12.11% 6

7 D. 12.1%, 6% 29. Which of the following bond prices, all with par value of N100, is most sensitive to market rate change? A. 5-year, 5% coupon rate, yield = 5.5% B. 3-year, 8% coupon rate, yield = 5.6% C. 7.5-year, 4.5% coupon rate, yield = 5.5% D. 10-year, 4.5% coupon rate, yield = 5.5% 30. You purchased an annual interest coupon bond one year ago that had 6 years remaining to maturity at that time. The coupon interest rate was 10% and the par value was N1,000. At the time you purchased the bond, the yield to maturity was 8%. If you sold the bond after receiving the first interest payment and the yield to maturity continued to be 8%, your annual total rate of return on holding the bond for that year would have been A. 7.00% B. 7.82% C. 8.00% D Which of the following loans is typically not secured? A. Collateral trust bond. B. Mortgage bond. C. Floating rate note. D. Equipment trust certificate. 32. Which of the following is/are false in relation to term structure of interest rates? I. Yield curve cannot have a negative slope. II. Yield spreads between high and low grade corporate bonds tend to widen during a boom period in the economy. III. Riding the yield curve is a strategy that requires purchase of long term bonds in anticipation of capital gains as yields fall with the declining maturity of the bonds. A. II only. B. I and II only. C. I and III only. D. II and III only. 33. Which of the following theories advocates that the investors are not indifferent to risk and they charge higher rates than the expected future rates, if the maturity of the instrument increases? A. Liquidity preference theory. B. Pure expectations theory. C. Loanable funds theory. D. Liquidity premium theory. 34. Which of the following statements is false regarding bond immunization? A. This is the strategy of matching the bond s duration with the time horizon of the investor. B. Investor can protect themselves from the interest rate risk through bond immunization. C. Immunization will provide a compound rate of return over the period immunized that equals the bond s YTM, irrespective of changes in market rates. 7

8 D. 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 investment horizon. 35. A bond has following features: Current price = N Modified duration = 6.76 years. What is the new price of the bond if the prevailing interest rate changes from 12% to 11%? A. N1, B. N1, C. N1, D. N1, A convertible bond has a par value of N1,000 and a current market value of N850. The current price of the issuing firm's stock is N27 and the conversion ratio is 30 shares. The bond's conversion premium is A. N40 B. N150 C. N190 D. N Which of the following types of investments experience the least interest rate risk? A. Zero coupon bonds. B. Long term Government bonds. C. Long term corporate bonds. D. Short term treasury bills. 38. Which of the following causes a lower required return on a bond? A. Dividend restrictions are placed on the company. B. The bond has no collateral. C. The bond is subordinated to other debt. D. (A) and (C) above. 39. Lara wants to buy a bond and hold it until it matures. Which of the following must occur if Lara is to realize a holding period return equal to the bond s yield to maturity? A. She must reinvest all coupons to earn the yield to maturity. B. The issuer must not call the bond away early. C. The issuer must make all payments in full and on schedule. D. All of the above. 40. Which of the following observations is relevant to a mortgage-backed security? A. Mortgage lenders originate loans and then sell packages of these loans in the primary market. B. Issuers of mortgage-backed securities buy their claim to the cash outflows from the mortgages as loans are paid off. C. It is an ownership claim in a pool of mortgages or an obligation that is secured by such a pool. D. Investors cannot buy and sell securitized mortgages like other bonds. Total = 40 marks 8

9 SECTION B: SHORT ANSWER QUESTIONS Question 2 Corporate Finance Give three reasons why debt finance might be considered more attractive than equity finance in the funding of a company acquisition. Question 3 Equity Valuation and Analysis Explain what is meant by economic recession and discuss the impact on the stock market. (4 marks) Question 4 Fixed Income Valuation and Analysis Explain what is meant by a deep-discount bond and why an investor might be interested in investing in such bonds. Question 5 Corporate Finance The management of Mambilla Powers Limited intends to expand its production capacities. The initial capital outlay amounts to N300,000 (year 0). One year later (year 1) a storage site must be bought for N350,000. Starting in the first year, management expects to generate a cash inflow of N210,000 for each year over the subsequent four years (years 1 to 4). The opportunity cost of capital amounts to 12%. 5(a) Calculate the NPV of the project. 5(b) The Chief Finance Officer (CFO) has expressed fears that accepting the new project might result in a reduction in the company s sales revenue. He estimates that the current sales revenue of N1 million yearly will decrease by 5%. Assuming the CFO is right, what would be your recommendation to the company? (4 marks) 5(c) For this project, the company has spent N100,000 for research and development during the past 12 months. How does this new fact change your project evaluation? 5(d) 5(e) How does the project value change if, at the beginning of the project, the project will lead to an increase in net working capital amounting to N100,000 and, at the end of the project life time, will lead to a decrease in net working capital by the same amount? (An explanation is sufficient. No calculations necessary). The CFO had recommended the use of 12% as cost of capital for the project in 5(a) above because this is the opportunity cost of capital for the existing operations of the company. Is this appropriate? Justify. 9

10 Question 6 Equity Valuation and Analysis Although many analysts consider the discounted cash flow methods to be theoretically sound, they find its use in security valuation to be problematic. Assume you belong to the group of analysts who would rather use the price-toearnings multiple (PE ratio, P/E ratio) to value and compare stocks. You find that the P/E ratio method renders the equity valuation relatively easy and straight forward. 6(a) List and discuss three factors that make the P/E ratio an attractive, and therefore, widely used choice in pricing stocks and comparing the attractiveness of different stocks. 6(b) Despite its ease, using P/E ratios for valuation is not free of problems. Discuss briefly three potential problems associated with using P/E ratios for comparing stocks in the same country. 6(c) You have collected the following information about Super Stores, a discount retailer which is rapidly expanding in major Nigerian cities and Trendy Wares, a high-end retailer of fashion clothing for men and women with presence in prime retail locations in Lagos and Abuja: Super Stores Trendy Wares Historical and expected return on 14% 16% equity (ROE) Historical and expected dividend 32% 65% payout ratio Beta NSE All Share Index Expected return on index 10.5% Expected risk-free return 4.5% 6(c1) Calculate the required rate of return for Super Stores and Trendy Wares. 6(c2) Calculate the P/E (P 0 /E 0 ) ratios using the earnings in the most recent time period for both the companies. (4 marks) Hint: P 0 DPS DPS DPS1 (r g) 1 1 EPS Payout ratio 1 EPS 0 1 g Payout ratio 6(c3) On the Internet, you notice that Trendy Wares is trading at 20 times its forecasted earnings. Calculate the long-term growth rate implied in Trendy Wares current P 0 /E 1 ratio. 10

11 Question 7 Fixed Income Valuation and Analysis You are the head of the Fixed Income department of an Investment Bank. One of your clients, a high networth investor, Mr. Murphy has been attracted to the Nigerian bond market and has earmarked N10,000,000 for fixed income securities. The investment horizon is 5 years. He is considering investment in one of the following: Bond A - 12% Bonds of Ajaokuta Steel Limited (Face value N1,000) selling at par. These Bonds will be redeemed at par after 5 years. Interest is payable annually. YTM is 12% Bond B - 14% Bonds of Jalingo glass Ltd. (Face value N1,000) selling at N1,100. These Bonds will be redeemed at par after 7 years. Interest is payable annually. Duration is 5 years. Required: 7(a) Compute the duration of Bond A; and analyze the interest rate risk of Bond A and Bond B above, if the market interest rate increases by 1%. (8 marks) 7(b) 7(c) 7(d) You would like to help Mr. Murphy immunize the investment against any immediate change in interest rates. Which one of the aforementioned instruments will you recommend to him for this purpose? Give reasons. (2 marks) State whether the investment recommended in 7(b) above offers perfect immunization and also give conditions to be fulfilled for perfect immunization of a bond investment. (2 marks) Mr. Murphy recently heard about Mortgage Backed Securities (MBS), a relatively new type of fixed income securities in Nigeria and wants you to educate him more on it. You are required to write briefly on MBS highlighting the issues below: 7(d1) The meaning of (MBS) and how they differ from Asset Backed Securities (ABS). 7(d2) How prepayment risk and credit risk impact on MBS. 11

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