Q1

The following forecast is made for Kallang Ltd:

The ROCE (Return on Common Equity) for 2021 is 10%

The expected market return is 6% and the risk-free return is 2%. Kallang Ltd has an equity beta of 2.

Required:

For Kallang Ltd:

(a) Compute the AEG (Abnormal Earnings Growth) for 2022 and 2023. (10 marks)

(b) Compute the normal forward P/E (price-earnings) ratio expected as at 1 Jan 2021,

(1 mark)

(c) Explain whether its forward P/E ratio should be higher or lower than the normal forward P.E.

(5 marks)

(d) Explain whether its PB (Price-to-Book) ratio at  1 Jan 2021 should be higher, lower or equal to 1.

(5 marks)

(e) Compute its earnings growth rate (ex-dividend) for 2022 and 2023.

(2 marks)

(f) Compute its earnings growth rate (cum-dividend) for 2022 and 2023 (this assumes shareholders would reinvest the dividends at the required return).

(2 marks)

Q2

Great World Ltd statement of financial position as at 31 Dec:

Great World Ltd statement of shareholders’ equity:

Great World Ltd reported for the year 2020:

$m

Interest income

Interest expense

Sales

The company tax rate is 35%

Required:

For Great World Ltd

30

196

7452

(a) Prepare a reformulated statement of financial position for 2019 and 2020 and a reformulated statement of shareholders’ equity for year ended 2020.

(6 marks)

(b) Prepare a reformulated statement of comprehensive income for 2020.

(4 marks)

(c) Compute FCF (Free Cash Flow) for 2020

(2 marks)

(d) Compute the OPM (Operating Profit Margin), ATO (Asset Turnover Ratio) and RNOA (Return on Net Operating Assets) for 2020 using   opening figures for the denominators.

(3 marks)

(e) Compute ROCE (Return on Common Equity) and its first level break-

down for 2020.

(5 marks)

(f) The implicit cost for short term NBC is 3% after tax.  Compute for 2020 the ROOA (Return on Operating Assets) and OLLEV (Operating            Liability Leverage) and its determination of RNOA (Return on Net         Operating Assets).

(5 marks)

Q3

(a) Sinkpost Ltd current market price is $15 per share, and its book value is $5 per share. Analysts forecast that the firm’s book value will grow by 10 percent per year indefinitely, and the cost of equity is 15 percent. Given these  facts,  what  is  the  market’s  expectation  of the  firm’s  long-term average ROCE?

(5 marks)

(b) Given the information in Question 4 (a), what will be Sinkpost’s stock price if the market revises its expectations of long-term average ROCE to 20 percent?

(5 marks)

(c) Analysts reassess Sinkpost’s future performance as follows: growth in book  value  increases  to  12  percent  per  year,  but  the  ROCE  of the incremental book value is only  15 percent. What is the impact on the market-to-book ratio?

(5 marks)

(d) The Gong Tea Company plans to acquire Lau Lau Ice Cream Co. for $60 per share, a 50 percent premium over current market price.  Lee Ho, the CFO of Gong Tea, argues that this valuation can easily be justified, using a price-earnings analysis. “Gong Tea has a price-earnings ratio of 15, and we expect that we will be able to generate long-term earnings for Lau Lau Ice Cream of $5 per share. This implies that Lau Lau Ice Cream is worth $75 to us, well above our $60 offer price.” Do you agree with this analysis? What are Lee Ho’s key assumptions?

(10 marks)

Q 4

The following are summary income statement and balance sheet numbers for a firm (in millions of dollars). The firm has a required return for operations of 9%.

Required:

(a) Prepare a table for 2020 showing the following:

(i)           Return on common equity (ROCE)       (ii)          Return on net operating assets (RNOA)

(iii)         Free cash flow

(iv)         Net payments to common shareholders

(v)           Net payments to net debt holders

(vi)         Asset turnover

(vii)        Net profit margin

(viii)       Growth rate for net operating assets

Use   beginning-of-period   balance   sheet   numbers   in Calculate answers in % terms up to 2 decimal points.

(b) On the basis of these financial statements, forecast SF3 :

denominators.

(8 marks)

(i)          Abnormal operating income for 2021.                       (ii)         Growth rate of abnormal operating income for 2022.

(iii)         Abnormal earning for 2021 given cost of equity = 14.76%.

(iv)         Growth rate of abnormal earnings for 2022

(8 marks)

(c) Value the equity as at end of 2020 using the two methods:

(i)           Abnormal operating income valuation

(ii)          Abnormal earning valuation given cost of equity = 14.76%

(9 marks)

Q5

Firm  A  has  current  comprehensive  earnings  for  2020  of  £1m,  expects forthcoming  abnormal  earnings  for  2021  of £1m  and  subsequent  abnormal earnings growing by 2 percent per year. The book value of equity at the end of 2019 was equal to £99m. The interest rate is 8%. The firm will cease to exist after the end of 2022.

(a) Assuming that the firm trades in efficient markets:

(i)      What would be firm A’s expected price-to-book (PB) multiple?

(6 marks)

(ii)     What would be firm A’s expected price-to-earnings (PE)

multiple?

(6 marks)

(b) Introduce  and  discuss  a  strategic taxonomy with  implications  for the pricing of stocks (with respect to earnings and the book value of equity).

(10 marks)

(c) Can you apply this taxonomy to firm A?

(3 marks)

Q6

(a) A company New Drugs Ltd announces £15 million rise in profits. Is its stock price going to rise?

(10 marks)

(b) Assume New Medication Ltd is an identical company to New Drugs Ltd. The only difference between the two companies is that New Medication Ltd capitalises its R&D investments whereas New Drugs Ltd expenses them. In the same period when New Drugs Ltd announces £15 mln increase in earnings, New Medication Ltd announces £21 mln increase in earnings. How will the price of New Medication Ltd change relative to the price of New Drugs Ltd?

(8marks)

(c) Can accounting analysis improve accounting-based valuations? Why or why not?

(7 marks)

Q7

Extracts from the financial statements of SuperStar plc for the year 2020 are shown below (values in £m).

Balance Sheet Extract 2019

Inventory               1,900

Trade payables      (5,600)

Income Statement Extract 2020

Net Income       Depreciation     Interest expense

2020

2,130

(6,200)

2,130

(780)

(650)

Cash Flow Statement Extract 2020

Capital expenditures Loan issues

SuperStar’s tax rate is 23%.

(1,380)

(2,430)

Required:

(a) Calculate the free cash flow available to equity of SuperStar plc for the year 2020.

(10 marks)

(b) Assume that SuperStar’s free cash flow available to equity, calculated in (a), will remain constant in the foreseeable future. SuperStar is currently valued at £20,000 million. What is the firm’s implied cost of equity capital?

(5 marks)

(c) Calculate the free cash flow available to debt and equity of SuperStar plc for the year 2020.

(2 marks)

(d)What discount factor should be used in discounting the forecasted free cash flows to debt and equity?

(2 marks)

(e) Assume that SuperStar plc’s cost of debt is 7%. Its debt-to-equity ratio is 40% and its weighted average cost of capital is  14%. If SuperStar plc changes its capital structure so that its debt-to-equity ratio is 30%, what should its new cost of equity be in order for the company to retain the same weighted average cost of capital? The cost of debt does not change.

(6 marks)