### WEDNESDAY: 23 August 2023. Morning Paper. Time Allowed: 3 hours.

### Answer ALL questions. Marks allocated to each question are shown at the end of the question. Show ALL your workings. Do NOT write anything on this paper.

**QUESTION ONE**

1. Highlight THREE reasons why the equity market is important to the economy as a component of the financial system. (3 marks)

2. Outline THREE reasons why preference shares are considered less risky than ordinary shares as a type of equity security. (3 marks)

3. A trainee financial analyst makes the following statement, “No equity investor needs to understand valuation models because real-time market prices are easy to obtain online”.

**Required:**

Provide TWO criticisms for the above statement in support of the use of valuation models in equity valuation. (4 marks)

4. Charles John is evaluating Reliant Home Limited. He has gathered the following information:

1. Current free cash flow to the firm (FCFF) is Sh.745 million.

2. Outstanding number of ordinary shares is 309,390.

3. The equity beta is 0.90, risk-free rate is 5.04% and equity risk premium is 5.5%.

4. Before tax cost of debt is 7.1%.

5. Corporation tax rate is 34%.

6. Capital structure is 20% debt and 80% equity.

7. Long-term debt is Sh.518 million.

8. Growth rate of FCFF is estimated as follows:

• 8.8% annually in stage 1 from year 1 to 4.

• 7.4% in year 5, 6.0% in year 6 and 4.6% in year 7.

• 3.2% in year 8 and thereafter.

**Required:**

From the above information, compute the following:

Weighted average cost of capital (WACC). (2 marks)

Total value of the firm. (4 marks)

Total value of equity. (2 marks)

Value per share. (2 marks)

**(Total: 20 marks)**

**QUESTION TWO**

1. Explain THREE limitations of fundamental analysis as used in equity valuation. (6 marks)

2. Assess the appropriateness of the following alternative methods of issuing equity finance in primary markets:

Placing. (2 marks)

An offer for sale. (2 marks)

A public offer for subscription. (2 marks)

3. Joel Mutugi is an equity analyst and is researching the relative valuation of two companies operating in the same industry. Joel gathers the following information:

**Additional information:**

1. The current market price per share for Mambo Leo Ltd. and Zawadi Ltd. are Sh.150 and Sh.100

respectively.

2. The current number of outstanding shares for Mambo Leo Ltd. and Zawadi Ltd. is 5,000 shares and

2,000 shares respectively.

**Required:**

Calculate the following:

Price to earnings before interest, tax, depreciation and amortisation (P/EBITDA) for Mambo Leo and

Zawadi Ltd. (4 marks)

Enterprise value (EV) to EBITDA for Mambo Leo Ltd. and Zawadi Ltd. (4 marks)

**(Total: 20 marks)**

**QUESTION THREE**

1. Explain the following competitive strategies as used in industry analysis:

Defensive competitive strategy. (1 mark)

Offensive competitive strategy. (1 mark)

Low cost strategy. (1 mark)

Differentiation strategy. (1 mark)

2. Assess TWO uses of dividend discount model (DDM) in equity valuation. (4 marks)

3. Java Ltd. is expecting a Return on Equity (ROE) of 15% over each of the next five years. Its current book value is Sh.5.00 per share, it pays no dividends and all earnings are reinvested. The required return on equity is 10%. Forecasted earnings in year 1 through year 5 are equal to ROE times beginning book value.

**Required:**

Calculate the intrinsic value of the company using the residual income model, assuming that after 5

years, continuing residual income falls to zero. (5 marks)

Calculate the new intrinsic value of Java Ltd. assuming that after year 5 Java Ltd.’s residual income will

decay over time to zero with a persistence factor of 0.4. (3 marks)

Calculate Java Ltd.’s intrinsic value assuming that at the end of year 5, Java Ltd.’s ROE falls to a

long-run average level and the price-to-book ratio falls to 1.2. (4 marks)

**(Total: 20 marks)**

**QUESTION FOUR**

1. Discuss THREE implications of the efficient market hypothesis (EMH) to financial market participants. (6 marks)

2. A financial analyst gathers the following information on Ndika Ltd.

Note: The data for the year 2019-2022 are actual and for the year 2023 are estimated.

The analyst estimates a required return of 15% and forecasts growth of dividends of 6% into perpetuity. Current share price is Sh.50.

**Required**:

Calculate the trailing price-to-earnings (P/E) as at 1 January 2023 ignoring any business cycle influence.

(2 marks)

Calculate the justified forward P/E using the Gordon growth dividend discount model. (2 marks)

3. At the beginning of the month of August 2023, KYM Ltd. shares were trading at Sh.52.72. In the previous year, KYM Ltd. paid a Sh.1.70 dividend that an equity analyst expects to grow at a rate of 4% annually for the next four years. At the end of year 4, the analyst expects the dividend to equal 35% of earnings per share and the trailing price to earnings (P/E) for KYM Ltd. to be 13. The required rate of return is 8%.

**Required:**

Calculate the price per share value of KYM Ltd. ordinary shares using the Gordon growth model (GGM).

(5 marks)

4. Jane Njoroge has gathered the following information relating to Baringo Stores Ltd. for the year ending 31 December 2022:

**Required:**

Estimate the value of Baringo Stores Ltd. using excess earnings method (EEM). (5 marks)

**(Total: 20 marks)**

**QUESTION FIVE**

1. With respect to technical analysis, state the application of the following principles:

Contrary opinion rule. (1 mark)

Follow the smart money rule. (1 mark)

Momentum indicators. (1 mark)

Stock price and volume techniques. (1 mark)

2. Describe FOUR stages of the industry life cycle. (4 marks)

3. Evaluate TWO drawbacks of price-to-earnings (P/E) ratio in valuation of companies. (4 marks)

4. The following statement of cash flows is available for Bidii Ltd., a private company:

**Required:**

Calculate the following:

Free cash flow to the firm (FCFF). (4 marks)

Free cash flow to equity (FCFE). (4 marks)

**(Total: 20 marks)**