EQUITY INVESTMENTS ANALYSIS MAY 2021 PAST PAPER

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 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 7.5% when the effective price increases 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)

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