Examination I Equity valuation and analysis Financial statement analysis Corporate finance Questions Foundation examination September 2008
FIRST PART: Multiple Choice Questions (52 points) Hereafter you must answer all 13 multiple choice questions. Please check the correct answers in the boxes. Only one answer is correct per question and you should check only one box. For each question you have first the number of points given for a correct answer and then the points subtracted for a wrong answer. If you do not answer a question it will count as zero points. If you change your mind, surround the marked answer. The answer surrounded with a circle will not count. 1. Financial Accounting (4 points / 1.33 point) A company owns bonds with variable interest rate. These securities are held with the aim of realizing capital gains in the near future. According to IFRS, which of the following assertions is correct? These bonds are measured at fair value and any gain or loss arising from a change in fair value is recognized in the income statement. These bonds are measured at fair value and any gain or loss arising from a change in fair value is recognized directly in equity. These bonds are measured at amortized cost and any gain or loss arising from a change in amortized cost is recognized in the income statement. None of the above answers is correct. 2. Financial Accounting (4 points / 1.33 point) Which procedures are permitted by IFRS for inventory valuation? FIFO, LIFO and weighted average cost. FIFO and weighted average cost. LIFO and weighted average cost. None of the above answers is correct. 3. Financial Statement Analysis (4 points / 1.33 point) If the return-on-equity ratio is 12.5%, the return-on-sales ratio 5% and the asset-turnover ratio 1.25, which of the following assertions is correct? Debts are higher than equity. Debts are lower than equity. Debts are equal to equity. Debts are equal to total assets. Page 1 / 10
4. Financial Accounting (4 points / 1.33 point) Calculate net income taking into account the following information: Net income / equity = 31% EBIT / total assets = 12% Interest rate = 8% Borrowed funds = 200 Tax rate = 50% 4.96. 13.05. 16. None of the above answers is correct. 5. Equity (4 points / 1 point) A firm decides to increase the speed of depreciation of its fixed assets. Assuming a tax rate of 35% and positive earnings before taxes, all other things equal, this means that: The free cash flows increase by 35% of the difference in depreciation. The free cash flows decrease by 35% of the difference in depreciation. The free cash flows increase by 65% of the difference in depreciation. The free cash flows decrease by 65% of the difference in depreciation. The free cash flows are unaffected by the firms depreciation policy. 6. Equity (4 points / 1.33 point) The current PE of a stock is 14. Assume a cost of equity of 11%, a dividend growth rate of 8.25% and a payout ratio of 25%. Assume neither any investment nor change in net working capital. It can be concluded that: The stock is undervalued. The stock is fairly valued. The stock is overvalued. No conclusion can be made with the information given above. Page 2 / 10
7. Equity (4 points / 1.33 point) What should be the price of a stock with a required rate of return of 13% and a 4% dividend growth when the next dividend payable in one year equals USD 2.50? USD 27.78. USD 30.28. USD 31.10. USD 31.39. 8. Equity (4 points / 1.33 point) Applying a three-stage dividend discount model, the stock s value will be greater (I) (II) the higher the expected growth rates. the lower the required rate of return. (III) the larger the expected dividends. Only (I) and (II) are true. Only (I) and (III) are true. Only (II) and (III) are true. All (I), (II) and (III) are true. 9. Corporate Finance (4 points / 1.33 point) ABC is a firm with a debt-to-equity ratio of 1. Without debt, the cost of equity would be 14%. The cost of debt is 10%. What is the cost of equity if there are no taxes? 12%. 14%. 16%. 18%. Page 3 / 10
10. Corporate Finance (4 points / 2 points) A firm should invest in a new investment project only when: It does not pay dividends. The expected return on the investment project is greater than the expected return on investment projects with similar risk. Expectations on the stock market are good. 11. Corporate Finance (4 points / 1.33 point) Firms with very cyclical revenues and high fixed costs usually have: Low asset betas. High asset betas. Asset betas of 0. None of the above: asset betas depend upon betas of debt and equity. 12. Corporate Finance (4 points / 1.33 point) The risk-free rate is 5%. A new project requires an initial investment of 100 and will be able to generate additional risky cash flows of 120 for the next 2 years. You should: Reject the project. Accept the project because its NPV (Net Present Value) is positive. Accept the project because the IRR (Internal Rate of Return) is greater than the cost of capital. No answer can be given. 13. Corporate Finance (4 points / 1.33 point) The market value of firm XYZ is 3,500 and debt is worth 500. In a Modigliani-Miller world with taxes, how much is the change in the firm s value if the company issues new shares worth 200 in order to reduce its debt? The corporate tax rate is 34%. -68. +68. +102. None of the above answers is correct. Page 4 / 10
SECOND PART: Open Questions (138 points) Question 1: Accounting (13 points) Snips & Scissors, an Asian company, has a joint venture in the US. The operations of the US entity are controlled by the Asian company. The US joint venture started operations on 1st January, 2007. Given below are the balance sheet and income statement (in million USD) of the US based operations for the year ending 31st December, 2007. Balance Sheet of the US joint venture as of 31st December, 2007 Assets Property, plant and equipment 350 Inventories 600 Receivables 350 Cash 100 Total assets 1,400 Liabilities 400 Equity Capital 800 Net income 200 1,000 Income statement of the US joint venture for the year ending 31st December, 2007 Sales 850 Cost of goods sold - 400 Gross margin 450 Depreciation - 100 Other expenses - 150 Net income 200 Assume that the exchange rate as of 31st December 2007 is 1 USD = 0.72 CU (Currency Unit) and that the average rate for the year was 1 USD = 0.74 CU. Fixed assets were purchased at the beginning of the year when the exchange rate was 1 USD = 0.76 CU. a) Translate the financial statements of the joint venture into the currency of the parent company (CU) using IFRS. (10 points) b) Calculate the exchange gain/loss for the year 2007. (3 points) Page 5 / 10
Question 2: Corporate finance and Equity (28 points) The balance sheet and income statement at the end of 2007 of Logitron are the following: Balance Sheet as of December 31, 2007 (in EUR thousand) Trade accounts receivable 2,190 Trade accounts payable 600 Inventories 900 Long-term debt 1,500 Net property, plant and equipment 1,410 Equity 2,400 Total assets 4,500 Total liabilities and equity 4,500 Income Statement as of December 31, 2007 (in EUR thousand) Sales revenues 4,500 Cost of goods sold -2,000 Gross profit 2,500 Selling, general and administrative expenses -1,000 EBITDA 1,500 Depreciation -300 EBIT 1,200 Interest expenses -75 Income before taxes 1,125 Taxes -450 Net income 675 Logitron is a non growth company. The company is expected to generate in perpetuity the same free cash flow to the firm (FCFF) generated in 2007. Logitron s corporate tax rate is 40%. Investments are expected to offset depreciation. The market value of debt equals its book value. The cost of debt is 5%. The market value of equity is 4,800 (thousand) EUR and there are 100 shares outstanding. a) Calculate the free cash flow from operations for 2007. (6 points) b) Determine the weighted average cost of capital (WACC). [Hint: Assume that the value of the firm equals the present value of expected free cash flows and that only long-term debt bears interest. For the candidates who have not answered a), use a free cash flow from operations of 700.] (6 points) c) Calculate Logitron s cost of equity. (5 points) d) What would have been the cost of equity if Logitron were an unlevered firm? (5 points) e) The management is planning to repurchase part of Logitron shares by issuing 1,000,000 EUR of additional perpetual debt. The average cost of debt will remain unchanged. Calculate the value of the additional tax shield and the value of the firm after the stock repurchase. (6 points) Page 6 / 10
Question 3: Accounting (20 points) The balance sheet and income statement of Stickers Ltd as of 31 December 2007 are reported below. (in million CU (Currency Unit)) Assets 2006 2007 Cash 80 2,000 Accounts Receivable 1,500 500 Inventory 1,000 400 Plants 1,485 1,300 Buildings 2,700 2,300 6,765 6,500 Liabilities & Shareholders' Equity 2006 2007 Financial Short Term Debts 1,200 580 Accounts Payable 860 360 Bond Loans (Long Term) 1,455 1,180 Financial Long Term Debts 2,250 1,420 Shareholders Equity 1,000 2,960 6,765 6,500 Profit & Loss 2007 Sales 5,000 COGS (1,000) Gross Margin 4,000 Overhead Expenses (450) Depreciation (500) Interest Expenses (250) Profit before taxes 2,800 Taxes (840) Net Profit 1,960 Overhead expenses, interests and taxes were paid in 2007. Using the above information, calculate (for the year 2007): a) Cash received from customers during the year. (3 points) b) Cash paid to suppliers. (5 points) c) Cash flow from operating activities using: c1) The direct method. (4 points) c2) The indirect method. (8 points) Page 7 / 10
Question 4: Equity (24 points) Crystal Garden, a fast growing luxury jewellery company with 25 million shares outstanding, is currently in its first year of operations and has reported a net income of EUR 75 million in August 2008. The firm has a debt to equity ratio of 10% at present. The book value of the firm s debt is EUR 30 million and the average interest rate on it is 5%. The firm is expected to have a high growth period for the first 5 years of its operations. From the sixth year onwards, i.e. from September 2012, the firm is expected to attain an annual stable dividend growth rate of 8% and an expected ROA (return on assets) of 13%. The firm has a long term target debt to equity ratio of 35%. Assume no taxes. a) What is the expected growth rate in earnings during the initial period of high growth (5 years) if the dividend payout during this period is expected to be 20%? (6 points) b) What is the expected dividend payout ratio after the period of high growth, if the average interest rate on debt remains unchanged? (6 points) c) If the cost of equity for Crystal Garden s stock is 12% and the dividend payout ratio is 20%, what is its current expected price? (12 points) Page 8 / 10
Question 5: Financial Statement Analysis (34 points) Given below are the financial statements of Weber Solutions Inc. for the past 5 years. Balance Sheet of Weber Solutions Inc. ('000 CU) Assets June 08 June 07 June 06 June 05 June 04 Current Assets Cash 6,438.00 3,016.00 3,922.00 4,846.00 4,975.00 Net Receivables 5,196.00 5,129.00 3,671.00 3,250.00 2,245.00 Inventories 4,729.00 4,795.00 3,939.00 3,260.00 2,221.00 Short term investments 42,610.00 35,636.00 27,678.00 18,952.00 12,261.00 Total Current Assets 58,973.00 48,576.00 39,210.00 30,308.00 21,702.00 Net Fixed Assets 19,427.00 18,128.00 18,582.00 19,629.00 15,983.00 Other Non-current Assets 1,171.00 942.00 1,038.00 2,213.00 940.00 Total Assets 79,571.00 67,646.00 58,830.00 52,150.00 38,625.00 Liabilities and Shareholders' Equity June 08 June 07 June 06 June 05 June 04 Current Liabilities Accounts Payable 1,573.00 1,208.00 1,188.00 1,083.00 874.00 Short-Term Debt 1,416.00 1,145.00 742.00 557.00 396.00 Other Current Liabilities 10,985.00 10,391.00 7,324.00 8,115.00 7,532.00 Total Current Liabilities 13,974.00 12,744.00 9,254.00 9,755.00 8,802.00 Long-Term Debt 4,577.00 2,722.00 2,287.00 1,027.00 1,385.00 Total Liabilities 18,551.00 15,466.00 11,541.00 10,782.00 10,187.00 Shareholder's Equity Common Stock Equity 35,344.00 31,647.00 28,390.00 23,195.00 14,824.00 Retained Earnings 25,676.00 20,533.00 18,899.00 18,173.00 13,614.00 Total Shareholder s Equity 61,020.00 52,180.00 47,289.00 41,368.00 28,438.00 Shares Outstanding ( 000 units) 10,771.00 10,718.00 10,766.00 10,566.00 10,218.00 Income statement of Weber Solutions Inc. ('000 CU) June 08 June 07 June 06 June 05 June 04 Sales 32,187.00 28,365.00 25,296.00 22,956.00 19,747.00 Cost of Goods Sold 5,686.00 5,191.00 3,455.00 3,002.00 2,814.00 Gross Profit 26,501.00 23,174.00 21,841.00 19,954.00 16,933.00 SG&A Expenses 7,619.00 6,297.00 5,742.00 5,006.00 3,953.00 R&D Expenses 6,813.00 9,290.00 9,183.00 3,971.00 2,970.00 Operating Income 12,069.00 7,587.00 6,916.00 10,977.00 10,010.00 Non-operating Income 3,398.00 4,926.00 5,501.00 3,497.00 2,021.00 Interest Expenses 600.00 520.00 300.00 180,00 140.00 Income Before Taxes 14,867.00 11,993.00 12,117.00 14,294.00 11,891.00 Income Taxes 4,733.00 3,684.00 3,804.00 4,854.00 4,106.00 Net Income 10,134.00 8,309.00 8,313.00 9,440.00 7,785.00 Diluted EPS 0.94 0.78 0.77 0.89 0.76 Share price (CU) 26 27.5 37 40 45 Page 9 / 10
a) Evaluate the liquidity position of the company with the help of ratios and suggest changes (if any) that the company could undertake. (10 points) b) The ROA for the company has fallen over the years. Analyze the reasons by decomposing this ratio and identify areas where the company needs to focus its attention to improve its profitability. (18 points) c) The EPS of the company is on an upward trend but the stock price is on the way down. Give possible reasons for this situation. (6 points) Question 6: Corporate Finance (10 points) On March 10, 2008, before the stock market has opened, Happy Ltd. announced a 20% increase in its profits for 2007, yet maintained the dividend unchanged. At the end of the day, after the stock market has closed, the shares of Happy Ltd. have dropped 6%. According to the Modigliani-Miller dividend indifference theorem, the dividend policy of a firm should not affect its value. Why then did the shares drop? Question 7: Equity (9 points) Financial analysts often use simple methods to value stocks. One of these methods consists in multiplying the average price/earning (PE) ratio of the industry the company is working in by the last reported profit of the company. For example, if the average PE is 12 and the earning per share (EPS) of the company K is CHF 3.5, then the price of the stock K is 12 3.5 = CHF 42. Mention three main problems of this method. Page 10 / 10