SINGAPORE INSTITUTE OF MANAGEMENT

PRELIMINARY EXAM

PROGRAMME(S) : University of London Degree and Diploma Programmes

(Lead College: London School of Economics & Political Science)

SUBJECT : 143 Valuation & Securities Analysis

DATE : Monday, 14 March 2011

DURATION : 3 Hrs

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INSTRUCTIONS :-

DO NOT TURN OVER THIS QUESTION PAPER UNTIL YOU

ARE TOLD TO DO SO.

Candidates should answer FOUR of the following TEN questions: ONE from
Section A and ONE from Section B and TWO further questions from either
section. All questions carry equal marks.

Candidates are strongly advised to divide their time accordingly.

Total number of pages: 9 (including this page)

Pg 1/9
Section A
Answer at least one question from this section.
(You are reminded that four questions in total are to be attempted for this
paper with at least one from this section.)

1. Project Universe is a pharmaceutical firm. It reported earlier today

comprehensive earnings equal to £120m which were generated over the
past twelve months. Its book value of equity is currently £1bn, as it was
twelve months ago, and its cost of equity capital is 10%.

(a) Assuming that residual (abnormal) earnings follow a random walk:

(i) on which price-to-book ratio would you expect Project Universe

to trade in efficient markets?
[8 marks]

(ii) on which price-to-earnings would you expect Project Universe to

trade in efficient markets?
[4 marks]

(b) Is it reasonable to assume that residual earnings follow a random

walk? Explain.
[5 marks]

(c) Assume now that residual earnings, AEt, follow the following
process:

AEt+1 = ρAEt + εt+1

with 0 < ρ < 1, cov(εt+i , εt+j) for all i≠j, and E(εt+i) =0 for all i.

Show that the price-to-book ratio Project Universe is trading on in

efficient markets is increasing in the persistence of residual
earnings.
[8 marks]
Hint: For any x, with 0 < x < 1:

i = +∞
1
∑x =
i

i =0 1− x

Pg 2/9
2. Consider Cool London plc. The firm’s cost of equity is 12%, the cost of
debt is 5% and the weighted average cost of capital is 9%. Extracts from
reformulated financial statements are as follows (values in millions of
pounds):

2009 2010
Property, Plant, and
Equipment 12000 19500
Accounts receivables 5100 4300
Inventories 5100 5250
Operating liabilities 12000 14500
Investments in bonds 1500 2000
Financial liabilities 3000 2500
Common equity 8700 14050

Sales 5100
Operating expenses 1260
Depreciation 300
Net interest revenues 120
Tax expense 100
Net income 3560

(a) Calculate the free cash flow (FCF) of London Care plc in 2010.
[9 marks]

(b) “By investing in short-term marketable securities to absorb excess

cash, the firm reduces its reported cash flow after investing activities
prepared according to the GAAP (General Accepted Accounting
Principles)”. Discuss.
[8 marks]

(c) Theoretically derive the present value of abnormal earnings (PVAE)

from the present value of expected dividends (PVED).
[8 marks]

Pg 3/9
3. Answer all parts of this question.

a) Do earnings follow a random walk? Do you expect the same behaviour

for Return on Common Equity (ROCE)? Explain.
[8 marks]

b) Explain the empirical evidence reported in the following table by

Penman.
[9 marks]

Return on Common Equity (ROCE) and Price-Earnings (P/E) Ratios for

Varying Levels of Levered Free Cash Flow (FCF) Based on all NYSE, AMEX,
and NASDAQ firms for 1973-1990
FCF Group FCF/Price (%) ROCE (%) P/E
1 87.1 4.7 17.4
2 23.4 9.2 10.3
3 10.8 12.1 9.6
4 6.3 13.7 10.4
5 2.2 14.6 11.6
6 -1.4 13.2 13.0
7 -6.1 12.6 12.8
8 -13.4 11.6 12.5
9 -25.9 9.9 12.2
10 -78.8 4.2 22.7

c) Theoretically derive the link between business profitability (Return on

Net Operating Assets, RNOA) and bottom line profitability (Return on
Common Equity, ROCE).
[8 marks]

Pg 4/9
4. Consider the following values from First Corp’s financial statements:

Balance sheet (values in millions of £) 2009 2010

Current operating assets 40 41
PPE 250 254
Current operating liabilities 120 125
Long-term financial liabilities 80 75
Common shareholders’ equity 50 54

Income statement (values in millions of £) 2009 2010

Revenues 300 310
Gross margin 120 125
Depreciation 20 22
Tax on operating income 20 23
Operating income after tax 80 75
Net financing expenses 10 8
Comprehensive earnings 70 67

Assume that the cost of the firm’s capital, rF, is equal to 7%, the cost of the
firm’s equity capital, rE, is equal to 10%, and the growth rate, g, is equal to
1%.

a) In the context of simple forecasting, estimate the value of Abnormal

Operating Income and Abnormal Earnings in year 2011 under the
following methods: Forecasting from Book Values (SF1 Forecasting),
Forecasting from Earnings and Book Values (SF2 Forecasting) and
Forecasting from Accounting Rates of Return (SF3 Forecasting).
[12 marks]

b) In the context of simple forecasting, estimate the value of Net

Operating Assets and Common Shareholders’ Equity in year 2010
under the following methods: Forecasting from Book Values (SF1
Forecasting), Forecasting from Earnings and Book Values (SF2
Forecasting) and Forecasting from Accounting Rates of Return (SF3
Forecasting).
[13 marks]

Pg 5/9
5. Answer all parts of this question.

a) What are the determinants of price-to-book ratios (PB) in efficient

markets?
[4 marks]

b) What are the determinants of price-to-earnings ratios (PE) in efficient

markets?
[4 marks]

c) Introduce and discuss a strategic taxonomy with implications for the

pricing of stocks (with respect to earnings and the book value of
equity).
[8 marks]

d) Consider the following sample of airlines:

Airlines Trailing PE Ratios PB Ratios

A 13.0 1.2
B 32.1 0.8
C 15.2 2.1
D 26.8 4.9

Apply the above taxonomy to this sample of airlines. Explain.

[9 marks]

Pg 6/9
6. Manufactured Earnings is a “darling” of Wall Street’s financial analysts. Its
current market price is $15 per share and its book value is $5 per share.
Analysts forecast that the book value of equity per share will grow by 10% per
year indefinitely and the cost of equity capital is 15%.

a) What is the financial market’s expectation of the long-term’s Return

on Common Equity (ROCE)?
[10 marks]
Hint: For any x, with 0 < x < 1:
i = +∞
1
∑x =
i

i =0 1− x

b) What will be Manufactured Earnings stock price if the financial

market revises its expectation of the firm’s long-term ROCE upwards
to 20%?
[5 marks]

c) Analysts reassess Manufactured Earnings’ future performance in the

following way: growth in the book value of equity increases to 12%
per year whilst the ROCE on the incremental book value is only 15%.
What is the impact of this reassessment on Manufactured Earnings’
price-to-book ratio? Explain.
[5 marks]

d) In which circumstances may incremental growth in a firm’s future

revenue have no impact on the firm’s fundamental equity value?
Explain.
[5 marks]

Pg 7/9
Section B
Answer at least one question from this section.
(You are reminded that four questions in total are to be attempted for this
paper with at least one from this section.)

7. Answer all parts of this question.

(a) Explain what contrarian investment strategies are about and

provide empirical evidence on their returns in the context of
fundamental and technical analysis.
[13 marks]

(b) On what basis would contrarian analysts refute the arguments put
forward by Fama and French (1992) and argue that contrarian
strategies generate abnormal returns? Explain.
[6 marks]

(c) How is it possible for the literature to report superior returns to both
momentum and contrarian strategies? Explain.
[6 marks]

8. Answer all parts of this question.

(a) It is often argued that, if any earnings management ever takes

place, it is more likely to take place during IPOs. Discuss.
[6 marks]

(b) How would you test for earnings management in the context of
IPOs?
[6 marks]

(c) Provide empirical evidence on returns to accounting analysis in the

context of IPOs.
[10 marks]

(d) Discuss implementation issues associated with investment

strategies designed to exploit mispricing of IPOs.
[3 marks]

Pg 8/9
9. Answer all parts of this question.

(a) Provide empirical evidence on the magnitude of the changes in stock

prices around the release of earnings information.
[8 marks]

(b) Describe and discuss the methodology used in capital market research to
test the usefulness of earnings to investors?
[9 marks]

(c) Discuss the competing hypotheses to explain the earnings response

conundrum.
[8 marks]

10. Answer all parts of this question.

(a) In the context of full information forecasting, which methods work best for
forecast over a finite five-year horizon?
[8 marks]

(b) What are the main limitations of the dividend discount method and the
discounted cash flow method?
[8 marks]

(c) How does the abnormal operating income method work? What
assumptions can be made to calculate the continuing value?
[9 marks]

Pg 9/9