THURSDAY: 20 May 2021. Time Allowed: 3 hours.
Answer ALL questions. Marks allocated to each question are shown at the end of the question. Show ALL your workings.
QUESTION ONE
1. Explain the following types of market organisation used in the securities market:
Auction market. (1 mark)
Brokered market. (1 mark)
Dealer market. (1 mark)
2. The following information relates to the central order book of Dolphin Ventures Limited, a company quoted at the Securities Exchange:
Sell orders Buy orders
Quantity Limit (Sh.) Quantity Limit (Sh.)
5,000 151 5,000 146
20,000 150 20,000 144
10,000 149 10,000 143
5,000 148 20,000 142
5,000 147 10,000 141
Required:
Alfred Ngugi has entered a market order to purchase 15,000 shares of Dolphin Ventures Limited.
Advise him on the price at which he should buy the shares. (2 marks)
Compute the average trade price of the shares based on your answer in (i) above. (1 mark)
Suppose that Alfred Ngugi had instead wanted to sell 10,000 shares of the company.
Determine the price at which he would sell the shares. (2 marks)
Outline four macroeconomic indicators that could influence the securities market in your country. (4 marks)
3. An analyst gathered the following information regarding Beta Ltd.:
Expected earnings per share for 2020 Sh.3.34
Retention rate 0.40
Required rate of return 12%
Current share price Sh.40
Dividends are paid out at the end of the year and are expected to grow at the rate of 6% into perpetuity.
Required:
The fraction of the company’s leading price to earnings ratio that comes from the present value of growth opportunities (PVGO). (5 marks)
Explain three causes of a negative present value of growth opportunities (PVGO). (3 marks)
(Total: 20 marks)
QUESTION TWO
1. Examine five steps that are involved in the equity valuation process. (5 marks)
2. Using relevant diagrams, explain three types of technical analysis charts that are used by equity analysts while forecasting the movement of the prices of shares. (6 marks)
3. An analyst gathers the following information about Zeb Limited shares:
Current market price per share Sh.22.56
Current annual dividend per share Sh.1.06
Annual dividend growth rate for years 1 — 4 9.00%
Annual dividend growth rate for years 5 and above 4.00%
Required rate of return 12%
Required:
Using the Two-Stage Dividend Discount Model, compute the intrinsic value of the share and comment on the results. (5 marks)
4. Smartprint Ltd. is a large-scale printing firm quoted on the Securities Exchange. The company is considering investing Sh.500 million in new printing equipment. The present value of the future after-tax cash flows resulting from the equipment is Sh.750 million. Smartprint Ltd. currently has 100 million shares outstanding, with a current market price of Sh.45 per share. Assume that this project’s new information is independent of other expectations about the company.
Required:
Determine the effect of the new equipment on the value of Smartprint Ltd. (3 marks)
Comment on the effect of the results obtained in (i) above on Smartprint Ltd.’s share price. (1 mark)
(Total: 20 marks)
QUESTION THREE
1. Summarise four factors that could justify the use of the residual income model in the valuation of equity. (4 marks)
2. The following information relates to Sky Blue Ltd.:
Debt Sh.20,000,000
Long-term growth of revenues and after tax operating income 5% annually
Gross profit margin 40%
Depreciation 2% of sales
Other operating expenses Sh.4,000,000
Working capital required 10% of additional revenues
Sales Sh.100,000,000
Corporation tax rate 30%
Capital expenditure is expected to equal projected depreciation
expense plus 5% of incremental revenues
Required:
Explain whether a prospective investor should use reported earnings or normalised earnings in estimating the free cash flow to firm (FCFF) for Sky Blue Ltd. (2 marks)
Calculate the forecast free cash flow to firm (FCFF) for Sky Blue Ltd. for the upcoming year. (5 marks)
3. An analyst gathered the following data for TZ Construction Ltd.:
Recent market price per share Sh.30
Number of shares outstanding 40 million
Sh.”000″
Market value of debt 120
Cash and marketable securities 75
Investments 200
Net income 160
Interest expense 9
Depreciation and amortisation 12
Taxes 48
Required:
Calculate the enterprise value to earnings before interest, taxes and depreciation (EV/EBITDA) multiple. (4 marks)
4. Wema Ltd. reported the following figures for the end of its financial year:
Revenues Sh.40.8 million
Pretax income 3h.8.6 million
Assets Sh.53.2 million
Liabilities Sh.27.8 million
Dividends per share Sh.0.35
Number of shares outstanding 8 million
Corporation tax rate 30%
The beta for Wema Ltd. is 1.2, the current risk free rate is 4.5% and the expected return on the market is 12.5%.
Required:
The value of the shares using a single-stage residual income model. (5 marks)
(Total: 20 marks)
QUESTION FOUR
1. Evaluate three momentum valuation indicators used in equity analysis. (6 marks)
2. Explain three applications of industry analysis in equity valuation. (6 marks)
3. Benson Mutisya has gathered the following data for a publicly quoted firm:
Sh.”000″
Net income 43,923
Sales 423,474
Average total assets during the year 486,203
Shareholders equity. beginning of the year 397,925
Dividends paid 1,518
Required:
The firm’s sustainable growth rate using the Dupont Model. (3 marks)
4. Big Store Limited (BSL) produces electronic toys for children aged between 2 and 12 years. The most recent income statement for BSL is given below:
Sh. “million”
Revenue 1,500
Cost of goods sold 630
Selling expenses 120
Administrative expenses 330
Operating profit 420
Allan Oketcli, a financial analyst, is forecasting BSL’s operating profit for the next financial year. He believes a new tax rate of 10% is going to be imposed on the revenue. Allan also believes that cost of goods sold and selling expenses are a fixed percentage of sales, while administrative expenses are fixed. BSL is expected to pass on the entire cost of the tax to the consumer. The price elasticity of demand for BSL toys is 0.75. that is, volume will decrease by 7.5% when the effective price increases by 10%.
Required:
The forecasted operating margin for the next financial year. (5 marks)
(Total: 20 marks)
QUESTION FIVE
1. Describe three disadvantages of using the price to book value ratio in equity valuation. (3 marks)
A firm has a return on equity (ROE) of 18%, an estimated growth rate of 13% and its shareholders require a return of 17% on their investments.
Required:
Based on these fundamentals, calculate the appropriate price to book value ratio for the firm. (2 marks)
2. The margin and sales tradeoff for QT Ltd. for next year are provided below:
Firm Strategy Retention Rate Profit margin Sales/book value of equity
QT High margin/Low volume 20% 8% 125
QT Low margin/High volume 20% 2% 4.00
The book value of equity of the firm is Sh.80 and has a required rate of return of 10%.
Required:
Calculate the firm’s leading price to sales (P/S) multiple assuming that it undertakes a high margin/low volume strategy. (3 marks)
3. Charles Magut is a financial analyst at Signature Investment Limited. He has compiled the following information about Reliant Properties Ltd.:
Growth rate of free cash flow to firm (FCFF) – 8.8% in Stage 1 comprised of years 1 – 4, 7.4% in year 5, 6% in year 6 and 4.6% in year 7, 3.2% in year 8 and thereafter
Capital structure 20% debt and 80% equity
Marginal tax rate 34%
Long-term debt Sh.1.518 billion
Cost of debt 7.1%
Equity beta 0.90
Risk-free rate 5.04%
Equity risk premium 5.5%
Current FCFF Sh.745 million
Outstanding shares 309.39 million
Required:
The required return for equity. (2 marks)
Weighted average cost of capital (WACC). (2 marks)
Total value of Reliant Properties Ltd. using Three-Stage FCFF. (6 marks)
Value per share of the company. (2 marks)
(Total: 20 marks)
