CONFIDENTIAL MAF653APRIL2018

UNIVERSITI TEKNOLOGI MARA

TEST 1

COURSE : FINANCIAL MARKET

COURSE CODE : MAF653
EXAMINATION : APRIL 2018
TIME : 1 HOUR 30 MINUTES

INSTRUCTIONS TO CANDIDATES

1. This question paper consists of THREE (3) questions.

2. Answer ALL questions. Start each answer on a new page.

3. Do not bring any material into the examination room unless permission is given by the
invigilator.

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QUESTION 1

a) Financial instruments can be classified by the type of claim that the holder has on the
issuer and one of the most common financial instruments is debt security.

Briefly describe five (5) key features of corporate debt securities.

(5 marks)

b) “The stock market is not going to achieve perfect efficiency anytime soon”.

Explain the above statement by referring to any two (2) arguments of market anomaly.
(5 marks)
(Total: 10 marks)

QUESTION 2

A. Mr Lim and Mr Cheah are stock market analyst who work for different Stockbroking
companies. Recently they are assigned to do a research on Profound Bhd and to
provide recommendation on the company’s shares. However, each has his own
preferable method in valuing shares whereby Mr Lim believes in the Price-Earnings
Approach, while Mr Cheah prefers the Dividend Valuation Model.

Information from the Profound recent Annual Report showed the following:

Total earnings after tax (EAT) = RM650 million

Number of shares outstanding = 400 million

Current Dividend per share = RM1 per share

Mr Cheah estimates the dividends will increase annually by 7% next year, 16% in year
2, 20% in year 3 and 14 % in year 4. Due to the industry becoming more competitive in
the future, he expects the dividends to grow at a stable rate of 6% per year from year 5
onwards. He assumes the required rate of return for this investment to be 10%.

Mr Lim forecasts company earnings per share to grow by 20% next year.He predicts that
the average industry price-to-earnings (P/E) ratio to be 15 times for next year.

Required:

a) Calculate each method of share valuation by Mr Lim and Mr Cheah. Show

separate calculations to arrive at your answers.

(8 marks)

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b) Advise with reasons which valuation method is more suitable if Profound is not
listed in the Kuala Lumpur Stock Exchange.

(2 marks)

B. A stock exchange can be considered as a marketplace where traders and member

brokers who represent investors meet to buy and sell stocks and other securities on
behalf of their clients.

Explain the TWO (2) types of stock exchange.

(3 marks)

C. Many companies which include large privately owned, small and medium-sized
companies enter the primary market to raise money from the public to expand their
businesses.

Explain what is an Initial Public Offering (IPO) in the primary market.

(2 marks)

D. Creative Berhad is expected to pay a dividend of RM0.90 per share in one year. In every
subsequent year, the dividend is expected to grow by 4% annually. Fazrin, who has
invested her money in Creative Berhad require a return of 10% on the firm’s stock.

Applying the Dividend Valuation Model:

a) Calculate the market price for the company’s shares and advise Fazrin if she should
sell her shares if the current market price of Creative Berhad is RM 18.
(3 marks)
b) Explain the Dividend Valuation Model theory.
(2 marks)
(Total: 20 marks)

QUESTION 3

A. Commercial paper is an unsecured, short-term loan or promissory note issued by

corporations with very high credit standing. Discuss two (2) advantages and
disadvantages of using this instrument for short-term financing.
(4 marks)

B. Suppose that in January 2018, you bought a bond from Axcel Berhad with the following
information:

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Annual coupon payment : RM 100

Maturity Date : December 2025

Principal : RM 1,000

Calculate for the yield to maturity if the bond is currently selling at RM 1,200 in the
market.

(5 marks)

C. An investor bought a bond 10 years ago that has RM 1000 face value and 15 years of
maturity period. The annual coupon rate for the bond is 10%. The required rate of return
is expected to be at 12%.
Required:

a) Calculate the present value of the bond 5 years ago if the interest is payable on an
annual basis.

b) Find the value of the bond for this year. Analyse your answers in (a) and (b).

c) The investor is planning to sell the bond next year and he expected the market price
for the bond will be RM 900 and the required rate of return will increased to 14%,
advise the investor whether he should sell the bond or not.
(11 marks)
(Total: 20 marks)

END OF QUESTIONS

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SOLUTION

QUESTION 1

a) Five (5) key features of corporate debt securities:

 Debt obligation requires a corporation to make periodic interest payments to the

holder of debt instruments.√
 Debt holders have a priority over the claims of equity holders in the case of
bankruptcy. In case of company liquidation, all assets will be distributed first to
those debt holders who have senior claims and then to those debt holders who
have junior claims. √
 Corporate debt securities are issued in two ways; private placement and sold in a
public offering. √
 A company can issue secured and unsecured debt. A secured debt means some
form of collateral is pledged to ensure the repayment of debt owed and for
unsecured debt, lenders don't have rights to any collateral for the debt. √
 Corporate debt can be issued with call provision or convertibility into common
shares. Call provision allowed securities to be repurchased prior to their maturity,
whereas convertibility provision provides debt securities to be converted into
common equities after a certain time period. √
(5√ x 1 mark each = 5 marks)

b) Market anomalies:

 Price-to-earnings ratio√
Lower price-to-earnings ratio tends to outperform the higher price-to-earnings
ratio It has been shown that investors can profit by investing in companies with a
low P/E ratio. Investing using the P/E ratio valuation has been an anomaly
against the Efficient Market Hypothesis (EMH).

 Size of the firm√

It has been shown that smaller companies, on a risk-adjusted basis, have greater
returns their larger peers.

 Calendar year/ January anomalies√

Small stocks have historically generated abnormally high returns during the
month of January. This is known as “turn of the year effect” Studies have found
that stocks consistently show higher returns at the turn of the month and Monday
tends to be the worst day to invest in stocks.

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 Firm specific announcement/ earnings reports√

It has been shown that an investor can profit from investing immediately when a
company reports/ firm announcement because it takes time for the market to
absorb the new information. This goes against the EMH.

(any 2 points√ x 0.5 mark each = 1 mark)

(2 explanation x 2 marks each = 4 marks)

Question 2

A. a) Mr Cheah Valuation

Year Dt-1 Dt DF (10%) PV

1 1 1.07 0.9091 0.9727

2 1.07 1.241 0.8264 1.026

3 1.241 1.489 0.7513 1.119

4 1.489 1.697 0.6830 1.159

4.28

P2 44.97 0.6830 30.71

34.99

1.697 √( 1+ 0.06 √ √ )
X 0.6830√ = 30.71
( 0.10−0.06) √ √
= 0.9727 + 1.026 + 1.119 + 1.159 + 30.71

= RM34.99 √ √ 15/3 = (5 marks)

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Mr Lim’s Valuation

Vo = PE x Forecasted EPS

RM 650 m
= 15 √ x √ x 1.20√
400 m√
= 15 √ x RM0.875√

= RM 29.25 √ 6/2 = (3 marks)

(8 marks)
b) Comments:

Mr Cheah’s method of using Dividend valuation model is more appropriate√ as compared to

income based valuation. In order to use income based valuation, the company must be
publicly traded√ because you need the market price of the stock to compute the PE ratio. √
Furthermore, Profound have a consistent dividend forecast every year. √

√ 4/2 = (2 marks)
B.

1) Physical Stock Exchanges√

Physically located and transactions are executed on a trading floor using a method
known as open outcry √

2) Virtual Stock Exchanges √

Equipped with a network of computers where trades are conducted electronically

through the actions of traders. √

(Types 2√ x ½ = 1 Marks)

(Explanation 2√ x 1 = 2 Marks)

C. Initial Public offering (IPO)

An IPO, is the very first sale of stock issued by a company to the public. It happens
when a privately owned company issues shares of stock to be sold to the general
public√ for the first time. √

(2 Marks)

D.

a) IV = RM0.90√

10% √-4%√

= rm15

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b) Fazrin should sell√ the stock because the current market price of the share (RM18) is
overvalued√ compared to the intrinsic value of the share (RM15) √

(6 √x ½ = 3 Marks)

c) DVM is based on the theory that equilibrium price for any security depends on the future
expected stream of income √from the security discounted using appropriate cost of capital or a
required rate of return√.

( 2 √ = 2 Marks)

Question 3

A. Advantages of investing in commercial paper:

i. Issuers are able to efficiently raise large amounts of funds quickly and at a relatively low
cost.

ii. Is a safe investment because the financial situation of a company can easily be
predicted over a few months.

iii. Issued by a wide variety of domestic and foreign firms including finance companies,
banks and industrial firms.

B. Disadvantages of investing in commercial paper:

i. Low rates of return, given their safety condition, commercial paper offer relatively low
yields.

ii. Short-term mature where investor need to constantly have to turn them over into new
investments since they mature so quickly.

iii. Available only to a few selected high credit rating and profitable companies.

(Any 2 advantages and 2 disadvantages x 1 mark = 4 marks)

B.
YTM: TRY i at 6%

= [100 (PVIFA 6%, 8√) + 1000 (PVIF 6%, 8)] – RM1200

= [100√ (6.2098) + 1000√ (0.6274)] – RM1200√
= RM 1,248.38 – RM 1200
= RM 48.38

YTM: TRY i at 7%√

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= [100 (PVIFA 7%, 8) + 1000 (PVIF 7%, 8)] – RM1,200

= [100 (5.9713) + 1000 (0.5820)] – RM1,200
= RM 1,179.13 – RM 1,200
= RM – 20.87

YTM = 6% √ + (48.38√ / 48.38 – (-20.87) √ (7% - 6%) √

= 6.6986%√
(10√ x 0.5 = 5 marks)

i. BPc = 100 PVIFA12%, 10 + 1000 PVIF12%, 10

= 100 (5.6502) //+ 1000 (0.3220) //
= 565.02 + 322
= RM 887.02 / (5√ x 0.5 = 2.5 marks)

ii. BPc = 100 PVIFA12%, 5 + 1000 PVIF12%, 5

= 100 (3.6048) √√ + 1000 (0.5674) √√
= 360.48 + 567.4
= RM 927.88 / (5√ x 0.5 = 2.5
marks)

When the maturity period decrease√, the bond price will increase √ (vice versa)
(2√ x 1 = 2 marks)

iii. BPc = 100 PVIFA14%, 4 + 1000 PVIF14%, 4

= 100 (2.9137) √√+ 1000 (0.5921) √√
= 291.37 + 592.1
= RM 883.47
(4 / x 0.5 = 2 marks)

Yes √, the investor should sell the bond next year because the bond is overpriced √
(2√ x 1 = 2 marks)