INV3701 EXAM MEMO 2020.

INV3701 EXAM MEMO 2020. Investments: Equity Asset Valuation. Which source of perceived mispricing does the active investment management attempt to identify? 1. The difference between intrinsic value and market price. 2. The difference between estimated intrinsic value and market price. 3. The difference between estimated intrinsic value and market price. 4. The difference between intrinsic value and estimated intrinsic value. An active investment manager attempts to capture positive alpha (risk adjusted return). A perceived mispricing is the difference between estimated intrinsic value and the market price of an asset. 2. Which statement is correct regarding an asset's value? 1. An asset's value is the present value of the sum of its past cash flows. 2. An asset's value is the present value of the sum of its future cash flows. 3. An asset's value is the present value of the sum of its past and future cash flows. 4. An asset's value is the future value of the sum of its past and future cash flows. An asset's value is the present value of the sum of its future cash flows. 3. If you prefer to use the P/E ratio rather than the P/S ratio, which statement will best support your preference? 1. Earnings are more stable than sales. 2. Earnings are a chief driver of investment value. 3. Earnings are not as easily manipulated as sales. 4. Earnings are positive even when the sales are negative. Page 3 of 22 INV3701 MAY/JUNE 2020 TURN OVER 4. What is the ownership perspective of the free cash flow approach? 1. A minority shareholder who has no direct control of the firm. 2. A controlling shareholder who has no direct control of the firm. 3. A controlling shareholder who can change the firm's dividend policy. 4. None of the above. A controlling shareholder who can change the firm's dividend policy. The ownership perspective of the FCF approach is that an acquirer who can change the firm’s dividend policy, which is a control perspective. 5. Xanthi Phokelo is an analyst at Afri Capital and reviews the valuation of two companies (A and B) by using the residual income model and the current market prices of the shares. This table summarises his findings: Company A B Market price R65 R50 Residual income model value R61 R55 Based on the information in the table, determine whether companies A and B are overvalued, undervalued or fairly valued. A overvalued (MP IV) B undervalued (MPIV) END OF SECTION A Page 4 of 22 INV3701 MAY/JUNE 2020 TURN OVER SECTION B – LONG QUESTIONS (60 MARKS) Question 1 [20 marks] Question 1.1 [6 Marks] An INV3701 student uses an example of three different companies to illustrate the valuation of shares from the perspective of a minority shareholder. • Firm A is a non-cyclical consumer products firm with a 40-year history. The firm pays R1.10 dividend per share and attempts to increase dividends by 4% a year. Earnings and dividends have steadily increased in the past 20 years. • Firm B is a technology firm. It has never paid dividends and does not expect to do so soon. Furthermore, due to large investments in new factories and equipment, the firm is not expected to generate positive free cash flow in the foreseeable future. • Firm C is a pharmaceutical firm that is currently enjoying high profits and paying dividends. However, the firm's best-selling drug is coming off patent in three years. With no other drugs in the pipeline, the firm's dividend growth rate is expected to drop abruptly in three years and settle at a lower growth rate. Briefly justify the appropriate valuation model for each of the three companies. Page 5 of 22 INV3701 MAY/JUNE 2020 TURN OVER Question 1.2 (2 marks) Karoo Limited listed its preference shares on the Johannesburg Securities Exchange (JSE) in 2019. They pay an annual dividend of R7.80 and the required rate of return is 6.50%. Calculate the value of the firm's preference shares. Question 1.3 (3 marks) Afrika Limited has a beta of 1.10 and its current dividend is R3.00. The equity risk premium and the risk-free rate is 9.00% and 4.50%, respectively. An analyst covering the shares expects Afrika's dividends to grow at 24% initially, declining linearly for ten years to a final and perpetual growth rate of 4%. Calculate the value of Afrika's dividend stream by using the Hmodel. Page 6 of 22 INV3701 MAY/JUNE 2020 TURN OVER Question 1.4 (9 marks) You have been assigned to analyse River Inc. You assume that River Inc's earnings and dividends will grow at a constant growth rate of 6%. The financial statements are from the most recent year, 2020, as well as other information about River Inc. The following information is available about River Inc. River Inc Balance Sheet 30 June 2020 R ('000) R ('000) Cash 200 Accounts payable 205 Receivables 245 Notes payable 425 Inventory 625 Other current liabilities 115 Total current assets 1070 Total current liabilities 745 Net property, plant and equipment 1 200 Long-term debt 0 Shareholders' equity 1 525 Total assets 2 270 Total liabilities and equities 2 270 River Inc Income Statement for the year ended 30 June 2020 R ('000) Sales 566 Depreciation 175 Other operating costs 251 Income before taxes 140 Taxes (30%) 42 Net income 98 Dividends 25 Page 7 of 22 INV3701 MAY/JUNE 2020 TURN OVER Common shares outstanding 100 Additional information: Required rate of return on equity 13.5% Growth rate of the industry 12% Industry P/E 25 a) Calculate the return on equity (ROE) and sustainable growth rate of River Inc for the year ended 30 June 2020. [6 marks] Page 8 of 22 INV3701 MAY/JUNE 2020 TURN OVER b) What is the effect on the sustainable growth rate of each of the policy changes that the board of directors of River Inc consider? Use the following table headings to answer the question. [3 marks] Proposal Effect on the sustainable growth rate (Increase, decrease or no effect) Component directly affected (if any) and how? (Justify your answer.) Increase in quarterly dividends Bond issue Share split Page 9 of 22 INV3701 MAY/JUNE 2020 TURN OVER Question 2 [20 marks] Question 2.1 [13 marks] Use the following information to answer questions a) to d).