**THURSDAY: 16 December 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. Distinguish between the following terms as used in equity markets:

“Primary market” and “secondary market”. (2 marks)

“Bull market” and “bear market”. (2 marks)

“Short selling” and “going long”. (2 marks)

“Bid” and “ask”. (2 marks)

“Limit order” and “market order”. (2 marks)

2. The current dividend on an equity share of Zep Ltd. is Sh.2.00. The firm is expected to enjoy an above normal growth rate of 20% for a period of 6 years. Thereafter, the growth rate will fall and stabilise at 10%. The equity investors require a return of 15%.

**Required:**

The intrinsic value of the equity share of Zep Ltd. (4 marks)

3. Adepo Limited’s current return on equity (ROE) is 16%. The company pays out 25% of its earnings as cash dividends. The current book value per share is Sh.35. The company has 5 million shares outstanding. It is assumed that the return on equity and dividend payout ratio will remain constant for the next four years. After that, competition forces the return on equity (ROE) to decline to 10% and the company increases the dividend payout ratio to 60%. The company does not plan to issue or retire shares. The cost of capital is 9.5%.

**Required:**

The value of Adepo’s Limited share that is attributable to growth opportunities (PVGO) assuming a growth rate of 4% after 4 years. (6 marks)

**(Total: 20 marks)**

**QUESTION TWO**

1. Discuss five stages of an industry life cycle model. (10 marks)

2. In relation to technical analysis:

Explain the term “Elliot wave theory”. (2 marks)

Describe four momentum oscillators. (4 marks)

Peterson Kamau is a technical analyst following Brightstars Ltd.’s shares in which he notices an inverted head and shoulders pattern. The neckline is at Sh.100, the shoulder is at Sh.90 and the head is at Sh.75.

**Required:**

Determine the price target for the company’s share. (2 marks)

3. Evaluate two instances where enterprise value to sales is appropriate for valuation of companies. (2 marks)

**(Total: 20 marks) **

**QUESTION THREE**

1. Highlight three drawbacks of price-to-book value in equity valuation. (3 marks)

2. David Obwogi an investor at the securities exchange intends to purchase XYZ Ltd.’s shares which he intends to hold for a period of four years. The expected dividend per share (DPS) is as follows:

**Year** **1** **2** **3** **4**

Dividend per share (Sh.) 6.00 6.50 7.50 9.00

David is hopeful of selling the shares in the secondary market at a price of Sh.120 after the end of four years. He expects a return of 20% on his investment.

**Required:**

The present value of the share to the investor. (3 marks)

Examine three limitations of Gordon Model in share valuation. (3 marks)

3. Ziwani Limited is expected to experience growth in three distinct stages in the future. The company’s recent free cash flow to equity (FCFE) is Sh.67.95 per share. The following information has been compiled about the firm:

**High-growth period:**

Duration of 3 years.

FCFE growth rate of 30%.

Shareholders’ required rate of return of 20%.

**Transitional period:**

Duration of 3 years.

FCFE growth will decline by 9% per year down to the indicated stable growth rate. Shareholder’s required rate of return of 15%.

**Stable-growth period:**

FCFE growth rate of 3%.

Shareholders’ required rate of return of 10%.

**Required:**

The value of the firm’s equity using three-stage FCFE model. (7 marks)

4. An equity market’s forecasted earnings per share (EPS) is Sh.15.30. The required real return on equity is 8% . The current dividend per share is Sh.10, current supernormal growth rate is 9.5%, a long-term sustainable rate of growth is 2% and a 20 year period of linear growth decline.

**Required:**

Using H-model, estimate the market’s forward price-earnings ratio. (4 marks)

**(Total: 20 marks)**

**QUESTION FOUR**

1. Examine four challenges of estimating discount rate in a private company valuation. (4 marks)

2. An equity analyst is examining a private firm under consideration as an acquisition and determines the following:

- The current capital structure is non-optimal because the owner avoids the use of debt.
- The industry risk premium reflects the additional risk in this industry compared to the broad market.
- A small stock premium and company-specific risk premium are determined because the private firm is much smaller and much less diversified than the public firms that beta is estimated from. The relevant figures are listed below:

Risk free rate 3.6%

Equity risk premium 6.0%

Beta 1.3

Small stock premium 3.0%

Company specific risk premium 2.0%

Industry risk-premium 1.0%

Pretax cost of debt 9.0%

Debt/total capitalisation for public firms in industry 30%

Optimal debt/total capitalisation 12%

Current debt/total capitalisation 3%

Tax rate 30%

**Required:**

The required rate of return on equity using:

Capital asset pricing model (CAPM). (2 marks)

Expanded CAPM. (2 marks)

Build-up method. (2 marks)

3. Fredrick Mull is valuing Quality Equipment Limited (QEL). He has made the following assumptions:

Book value per share is estimated at Sh.9.62 on 31 December 2021.

Earnings per share (EPS) will be 22% of the beginning book value per share (BVPS) for the next eight years.

Cash dividends will be 30% of EPS.

At the end of the eight year period, the market price per share (MPS) will be three times the book value per share.

The beta for QEL is 0.60%, the risk free rate is 5% and the equity risk premium is 5.50%

The current market price of QEL is Sh.59.38, which indicates a current price to book value (P/B) of 6.2.

**Required:**

Estimate the value per share of QEL stock using the residual income model. (7 marks)

Describe three weaknesses of the residual income model in equity valuation. (3 marks)

**(Total: 20 marks)**

**QUESTION FIVE**

1. Explain the term “random walk theory” as used in equity valuation. (2 marks)

Discuss three forms of market efficiency. (6 marks)

2. Evaluate two top-down approaches to modelling revenue. (4 marks)

3. There has been an increase in the number of zero income stocks in your country and the exposure to these stocks is becoming increasingly unavoidable.

**Required:**

In relation to the above statement, assess three key adjustments to the traditional present value approach necessary to avoid critical errors in the equity valuation process. (6 marks)

4. An equity analyst has gathered the following information:

Neutral rate 4%

Inflation target 3%

Expected inflation 7%

Gross Domestic Product long term trend 2% Expected Gross Domestic Product growth 0%

**Required:**

Estimate the short-term interest rate target using the Taylor rule. (2 marks)

**(Total: 20 marks)**