EXAMINATION I: Economics Corporate finance Financial accounting and financial statement analysis Equity valuation and analysis

Questions

Final examination March 2011

Question 1: Economics

(26 points)

At the end of 2009, China had accumulated foreign exchange reserves valued at around USD 2,400 billion. In 2009, these reserves had grown by about USD 450 billion. Political observers frequently point out that the Yuan (the Chinese currency) is undervalued in real terms. a) What are the three most important positions of the balance of payments? Briefly explain these positions and clearly point out the interactions between these positions in a situation where the central bank accumulates foreign reserves. (10 points) b) In order to identify the source of the real appreciation of a currency in general, give two conceptually different ways through which it can happen. (4 points) c) Now assume that the Chinese currency (Yuan) does in fact strengthen in real terms vis-vis the US-Dollar. State and explain the conditions that need to be in place with regard to the elasticities of exports and imports in relation to the real exchange rate so that the currency movement does lead to an improvement in the US current account. (6 points)

Over the past decades, the Chinese economy has been growing at exceptionally high rates. One useful approach to capture the sources of growth is the so-called growth accounting equation. Y A K L K L Y A K L d) According to the above equation, the sources of economic growth ( Y / Y ) are (1) growth in productivity ( A / A ), (2) growth in the capital stock ( K / K ) multiplied by the elasticity of output with respect to capital ( K ) and (3) growth in the labour force ( L / L ) multiplied by the elasticity of output with respect to labour ( L ). Clearly explain these variables in economic terms and also state how these variables can be measured empirically. (6 points)

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Question 2: Economics

(15 points)

In 2009, European governments, as well as the U.S. government, have reacted to the massive economic downturn with ambitious expansionary fiscal policy programs including tax cuts as well as massive expenditure increases for infrastructure projects and for social programs. a) Using the IS/LM-framework as well as the AS/AD-framework, show briefly the intended effects of these stimulus packages on GDP (growth) and unemployment, as well as on interest rates and the price level in the short term (when the wages are fixed). (4 points) b) One effect of these policies is a large increase in government deficits and in government debt to unprecedented levels as the massive expenditures need to be financed. What are the options of the governments to finance these expansionary policies? Give 2 of these options. (4 points) c) What will be the likely effects on financial markets of such massive increases in government borrowing? What will be the effect on (private) corporate borrowers? (4 points) d) What will be the longer term consequences of these large increases in government budget deficits and government debt levels? (3 points)

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Question 3: Financial Accounting and Financial Statement Analysis

(18 points)

The CFO of the ABS-Bank wants to explain the impact of the financial crisis on the financial statements of the company as of December 31, X1 at the annual shareholders meeting. The following topics will be addressed: Loans to corporate customers Available-for-sale financial assets

Explain how the following transactions and events defined in a), b) and c) have affected the net income, the accumulated other comprehensive income (other equity) and the cash flows from operating activities in the financial statements of the ABS-Bank as of December 31, X1. Tax effects shall not be considered. a) The par value of loans to customers amounted to CU (Currency Unit) 500,000,000 at 31.12.X1. Due to the expected economic slowdown in year X2 the ABS-Bank estimates on 31.12.X1 that the loan defaults during X2 will increase by around CU 50,000,000. Impact on ... ... net income

... accumulated other comprehensive income (other equity) ... cash flow from operating activities

(6 points)

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b) In the year X0 the ABS-Bank acquired collateralized debt obligations (CDOs) for CU 200,000,000, which were classified as available for sale financial assets in accordance with IAS 39. On 31.12.X0 the ABS-Bank adjusted the book value of the financial assets to the fair value of CU 180,000,000 without affecting the net income. Since the fair value of the CDOs had significantly declined to CU 70,000,000 on 31.12.X1, the ABS-Bank recognized an impairment loss. This impairment loss was recognized in the profit and loss account. Impact on ... ... net income

... accumulated other comprehensive income (other equity) ... cash flow from operating activities

(6 points) c) To improve the financial situation, the ABS-Bank sold a plot of land held for investment purposes in November X1 at a price of CU 10,000,000. The book value of the plot of land at the day of sale amounted to CU 2,000,000. Impact on ... ... net income

... accumulated other comprehensive income (other equity) ... cash flow from operating activities

(6 points)

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Question 4: Financial Accounting and Financial Statement Analysis

(32 points)

The following table contains data from the financial statements of XYZ Co. for 2010 (actual) and 2011 to 2014 (forecasts). a) Create forecast data based on the following assumptions to complete the forecast balance sheet and forecast profit and loss statement for 2011 - 2014. On the answer sheet fill in the forecast figures for FY2014. The amounts of fixed assets and liabilities on the balance sheet at the beginning of FY2011 all grow at a rate of 10% for the first 2 years; after that period they stop growing. Assume that shareholders' equity changes only as a result of net profits/losses and capital transactions, including dividend payments (i.e. Clean surplus accounting is maintained). The dividend payout ratio is 50%. Cash surpluses and shortfalls are adjusted with changes to current assets. All liabilities are related to operating activities and are interest-free. Sales grow by 5% in FY2011. Afterwards, the sales growth rate declines by 1% each year. The ratio of operating expenses to sales worsens by 1% each year from FY2010. The corporate income tax rate is always equal to the FY2010 actual figure.
(Unit: ,000 CU)

FY Year-end balance sheet Current assets Fixed assets Liabilities Shareholders' equity

2010 (actual)

2011 2012 2013 (forecast) (forecast) (forecast)

2014 (forecast)

1,000 3,000 2,500 1,500 3,300 2,750

Profit or loss statement Sales Operating expenses 1,000 700 1,050 786

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Operating profit Tax expense Net profit

300 120 180

304

(18 points) b) Based on the data above, use the DuPont analysis to explain the differences in profitability in 2011 and 2014. In your analysis, use balance sheet figures as at the beginning of the year. (8 points) c) Based on the data above, use the residual income model to calculate the intrinsic value of XYZ Co.'s equity capital at the beginning of FY2011. Assume that the cost of shareholders' equity capital is 10% per annum and that the terminal value can be ignored. [Note: residual income = net income (shareholders equity x cost of equity capital)] (6 points)

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Question 5: Corporate Finance and Equity Valuation and Analysis

(50 points)

In August 2010 Moogle Inc. went public on Nasdaq. Suppose you worked at this point in time as an investment analyst at one of the two lead managers of the Moogle Initial Public Offering (IPO). One of the main challenges for the involved investment banks as well as the issuing firm is to determine an adequate issue price for the IPO. Table 1 provides basic financial statement information for fiscal year 2009. Table 1: Basic financial statement information for Moogle Inc. (fiscal year 2009): Panel A: Income Statement (in million USD) Revenues - Depreciation - Other operating costs = EBIT + Net interest income = EBT - Taxes = Net income Panel B: Balance sheet (in million USD) Cash & Equivalents 298 Current Liabilities Receivables 407 Long Term Debt Other current assets 416 Total Equity Fixed Assets 622 Sum 1,743 Sum (Value of both Liabilities and Debt is equal to their book values.) 471 100 1,172 1,743 2,932 -110 -2,137 685 8 693 -482 211

a) Calculate the free cash flow (FCF) to firm of Moogle Inc. for the fiscal year 2009. The other operating costs include USD 459 million of non-cash relevant expenses. In fiscal year 2009 the net working capital has decreased by USD 12 million and capital expenditures amount to USD 628 million. The relevant corporate tax rate is 35%. (6 points)

In July 2010 Moogle Inc. and the underwriters set - after consulting institutional investors in several road shows - a price range between USD 108 and USD 135. Moogles long term debt (with a book value of still 100 million USD) consists of a straight bond (trading at par) with a coupon of 5.5% p.a. The current liabilities (with a book value of still 471 million USD) consist of a short term loan with interest payments of 6.5% p.a. The company has 30 million shares outstanding, the appropriate risk free rate is 0.5% p.a., and the expected market risk premium is 10% p.a.

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b) Calculate the WACC for Moogle Inc. Use the mid point of the IPO price range as a proxy for the (yet unobservable) share price. The two companies best comparable to Moogle Inc. exhibit the following characteristics: Comparison Firms Bahoo Inc. Xhoo Inc. Market Value (Debt+Equity) in million USD 6,523 2,586 Equity Beta 1.70 2.20 Asset Beta 1.1184 1.1924 Debt Beta 0 0 D/E Ratio* 0.80 1.30

*D/E Ratio is the Debt/Equity Ratio.

In your calculations, you should use a portfolio that comprises both of the comparison companies held on a market value weighted basis. The relevant corporate tax rate is again 35%. Use the CAPM approach in your calculations and a debt beta for Moogle Inc. of zero. [Hint: In order to get equity beta of Moogle, use the weighted average of asset beta from comparison companies and the equation in the Formulae Booklet.] (15 points) c) Suppose Moogles expected FCF to firm for fiscal year 2011 is USD 400 million and the relevant WACC is 10% p.a. Use again a total debt value of USD 571 million in answering the following questions. c1) Calculate for your boss the implicit expected (assumed constant until infinity) growth rate satisfying the upper point of the IPO price range for fiscal year end 2010. (10 points) c2) Suppose you calculated in c1) a growth rate of 1.5% p.a. Mr. Brawn, Moogles CFO, expects for his firm a corresponding FCF to firm growth rate of 4% p.a. This number is also in line with the average growth rate of a set of benchmark firms. Suppose for a moment that you are not affiliated with the two underwriters. Would you provide a BUY or a NOT BUY recommendation for Moogles shares based on the IPO price range of USD 108-135? Provide a brief explanation for your decision. (4 points) c3) Calculate a price target for Moogle shares based on the expected fiscal year 2011 FCF to firm (USD 400 million) and the corresponding expected growth rate of 4% p.a. (5 points) d) A member of your team is convinced that you should have used EVA (Economic Value Added) instead of the DCF-method used to value Moogle Inc. correctly. How is EVA defined? And what do you think of his opinion? (4 points)

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e) At the end of 2010 (after the IPO) Mr. Brawn (Moogles CFO) calculates a D/E ratio of 0.2 for his company. A young staff member of his team, Mrs. Chen, illustrates that a D/E ratio of 0.4 would be the optimal capital structure for Moogle in a world with corporate taxes. Mrs. Chen assumes in her analysis that bankruptcy costs would not increase due to a D/E ratio growth from 0.2 to 0.4. Thus, Mr. Brawn considers issuing bonds instead of equity to finance a set of new investment projects. Lets assume that the above assumption of a zero change in bankruptcy costs is correct. What would such a change in the firms capital structure imply for (i) Moogles WACC, (ii) its firm value, and (iii) the NPV of new investment projects? Indicate the precise cause of the expected phenomenon. (No calculations required.) (6 points)

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Question 6: Equity Valuation and Analysis

(39 points)

At the beginning of the fiscal year, Brown Co. had total assets of USD 5 billions, liabilities of USD 4 billions, equity of USD 1 billion (book value) and 10 million issued and outstanding shares. Below are the forecasts prepared for the company by analysts. The assumption is that the return on equity and dividend payout ratio will be maintained at the same levels as this year. Brown Co.'s Forecast for this Fiscal year (Unit: USD millions) Sales Operating profits Interest expenses Pretax profits Corporate income tax (40%) Net income Dividend 6,000 260 160 100 40 60 40

a) Brown Co.'s share price is currently USD 60. Calculate the price-to-earnings ratio (P/E) of Brown Co. and discuss two factors that make the P/E an attractive and widely used method for valuing stocks (6 points) b) b1) Calculate the sustainable growth rate. Then, determine the required rate of return of the Brown Co. stock. For this last calculation, use the CAPM and take a risk free rate of 4%, an equity market premium of 5% and a beta of 1.2. (4 points) b2) Taking the same parameters as in b1), what is the theoretical price of the Brown Co. stock? Compare it to the quoted price. Would you recommend buying the share? (3 points) b3) With a quoted price of USD 60, what are the implied growth rate and the implied ROE? [Hint: Assume the required rate of return of the Brown Co. stock and its payout ratio unchanged as in b1).] (3 points) b4) Based on the results found under b1) b3), explain the observed difference between the quoted and the theoretical price of the Brown Co. stock. (3 points) c) Brown Co. decides to increase its return on equity and earnings per-share by borrowing USD100 millions at an interest rate of 4% and using that money to repurchase its own shares on the equity market. Assuming that its own shares are repurchased at the current share price of USD 60 at the beginning of the year, calculate Brown Co.'s return on equity and earnings per-share. (8 points)
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d) Calculate the change in Brown Co.'s theoretical share price from the repurchase of shares at a share price of USD 60 taking account only of the present value of the tax shield from the interest on debt generated by the borrowing. (8 points) e) Brown Co. repurchased its own shares and its share price fell. Identify one factor that could be behind this outcome. (4 points)

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