Section A: Corporate Strategy

(Answer any 2 out of the 4 questions in this section)

 

Question 1

  • Explain why a firm in monopolistic competition can only make abnormal profits in the short run.
    • marks)

 

  • Explain how the imposition of a fixed tax affects a monopolist.

 

  • marks)

 

  • Why would a monopolist never choose to operate where the demand function was price elastic?
    • marks)

 

  • Explain the consequences for consumer surplus if a competitive industry becomes monopolised.
    • marks)

 

  • Explain the consequences for social welfare if a competitive industry becomes monopolised?
    • marks)

(Total 25 marks) Question 2

  • Discuss the benefits to firms of forming a cartel.

(10 marks)

 

  • Why do cartels often fail?

(15 marks)

(Total 25 marks)

 

 

Question 3

Company A estimates its demand function to be:

Q = 4500 – P

And its total cost function (TC) to be:

TC = 150,000 + 400Q Required:

  • Calculate the profit maximising output, price, and the level of profits.

(10 marks)

  • Explain what happens to the profit maximising output, price, and the level of profits, if the demand function changes to:

Q = 5000 – P

(10 marks)

 

(c) Explain what happens to the profit maximising output, price, and the level of profits, if a tax of 50 per unit of output was imposed.

(5 marks)

(Total 25 marks)

 

Question 4

Explain how the various types of price discrimination benefit monopolist and consumers.

(25 marks)

 

Section B: Valuation

(Answer any 2 out of the 4 questions in this section)

 

Question 5

  • Prior literature documents that P/E is the most popular valuation method. Discuss four investment situations for which P/E works better than the Discounted Cash Flow Model.
    • marks)

 

  • Assume that you are estimating the equity risk premium in a stock exchange over 1980 to 2020. To calculate the market return, you select a market capitalization-weighted index, consisting of the shares of 100 leading companies. The index was established in 1990. The backfilled returns from 1980 to 1989 are based on the initial 100 issues selected in 1990.The index is a price index and the incorporation of dividends in the index is available only from 2000 onwards. Interest rates were suppressed by regulation prior to 1990 and moved higher thereafter. Discuss which factors could bias the unadjusted historical risk premium estimate upward and which factors could bias the unadjusted historical risk premium estimate downward. Justify your answers.

(9 marks)

 

 

 

 

 

  • A stock’s current price is £10. The projected annual dividends are £2. The share price is expected to increase to £13 next year. If expected alpha is used to make the initial evaluation, explain what minimum information is required to judge whether the stock is fairly valued, overvalued or undervalued.
    • marks)

(Total 25 marks)

 

Question 6

(a) Assume you are valuing the stock of East Company. You have obtained the following information:

  • The book value per share is estimated at $10 at the end of current year.
  • Dividends payout policy is stable. Cash dividends paid will always be 50% of EPS.
  • The risk-free rate of return is 7% per year. The market return is 12% per year. The beta is 1.4. The equity risk premium is 5% per year.
  • Return on equity, measured as EPS divided by beginning book value per share, will be 40% for Year 1 and then will decrease to 30% for Year 2. From Year 3 and thereafter, return on equity will remain at 20%.
  • At the end of Year 3, the expected share price will be 2.5 times the book value per share.
  • The current share price is $40.
  • The clean accounting relations hold. There are no share repurchases or share issues.

 

 

 

Required:

  • Estimate the value per share of the East stock using the following two valuation methods respectively.
    • The residual income model (RIM)
    • The dividend discount model (DDM)

(14 marks)

  • Compared the results derived from RIM and DDM, judge whether the East stock is undervalued, fairly valued or overvalued. You consider any security trading within a band of ±10% of the estimate of intrinsic value to be within a fair value range.

(3 marks)

 

(b) John is researching the valuation of the stock of IND in the apparel retailer industry, listed in NYSE. He intends to use the average value of the P/B for the industry stocks as the benchmark because of IND’s current negative earnings. The average P/B is calculated as the arithmetic mean P/B value of another three stocks in the same industry and from the stock exchange (see the table below). Comparing the average P/B of

1.27 with the IND stock’s P/B of 0.52, John concludes the IND stock is undervalued.

Company Name P/B
RED2.98
ORA0.21
YEL0.62
Average1.27

 

 

Required:

Discuss four reasons why John’s conclusion may be in error.

(8 marks)

(Total 25 marks)

 

Question 7

(a) Assume you are valuing the stock of West Company, a pharmaceutical company. The extracts of West’s financial statements for fiscal years 2019 and/or 2020 ended on 31st December are shown in the tables below. Other information is as follows:

  • The share price at the end of 2020 is $60.
  • Net operating profit after tax (NOPAT) in 2020 is expected to grow 10% per year in 2021. After that, the growth rate of NOPAT will be 7%. Depreciation and amortisation expenses are the only non-cash charges.
  • The sales in 2020 are expected to grow 15% per year for the next year and 10% thereafter.
  • The depreciation and amortisation expenses are expected to grow always at the same rate as NOPAT. The fixed capital expenditures are expected to grow 10% per year in the next year and remain at 200% of depreciation and amortisation expenses from 2022.
  • In the next year, the noncash working capital at the end of each year is expected to be 25% of sales. After 2021, the investment in noncash working capital will grow at 7% each year.
  • The market value of debt is the same as the book value of debt. The number of shares outstanding is 1000 million, which is not expected to change over time.
  • The required return is 12% per year. The pre-tax cost of debt is 5% per year.

 

Extracts of Balance Sheet (in millions of dollars)

 Year 2019 Year 2020
Cash and cash equivalent50006000
Current assets1500020000
Non-current assets4500047000
Current liabilities1080013200
Non-current liabilities2820030800
Short-term debt18002200
Long-term debt1320017800
Shareholders’ equity2100023000

 

Extracts of Income Statement (in millions of dollars)

 Year 2020
Sales20000
Less: Cost of Sales5000
Less:        Depreciation    and amortisation expense3000
Less: Other operating expense2000
Operating profit10000
Less: Net interest expense1200
Less: Tax expense (tax rate = 20%)1760
Net profit7040

 

 

 

 

 

Extracts of Cash Flow Statement (in millions of dollars)

 Year 2020
Cash flow from operating activities: 
Net cash flow from operating activities3200
Cash flow from investing activities: 
Purchase of plant and equipment(2000)
Purchase of intangible assets(4000)
Net cash flow from investing activities(6000)
Cash flow from financing activities:  
Short-term borrowings400
Long-term borrowings4600
Net interest payment(1200)
Net cash flow from financing activities3800

 

Required:

  • Calculate the per-share free cash flow to the firm (FCFF) for West Company in 2020.

(5 marks)

 

  • Estimate the per-share value of the West stock at the beginning of 2021 using the FCFF Model.

(13 marks)

 

(b) Comment on the statement: “investment value should be driven by earnings but not dividends, so it is not appropriate to use the dividend discount model for the estimate of intrinsic value.”

(7 marks)

(Total 25 marks) Question 8

  • Assume you are using the subjective judgement method to value the stock of KK in the retailer store industry based on P/S. You have collected the following data for a group of stocks in the same industry from the same stock market.

 

CompanyP/SPMExpected growthbetaPayout
AA3.920.0729.00%1.450%
BB0.090.0112.00%1.1534%
CC0.220.0212.50%1.550%
DD0.270.1012.50%1.3038%
EE0.230.0615.00%1.4059%
FF0.820.029.50%1.3020%
GG0.670.0410.50%1.1041%
KK 0.38 0.05 15.00% 1.35 36%
LL0.900.0410.50%1.5019%
MM1.020.0418.50%1.3011%
NN0.310.0515.00%1.3565%

 

Required:

Compared to which stock(s), you can conclude KK is relatively undervalued/overvalued? Compared to which stock(s), your judgement is inconclusive? Provide detailed explanations for your answers.

(15 marks)

 

 

  • Discuss five investment situations for which the Dividend Discount Model (i.e. 𝑉0 𝐷 ) works better than the Free Cash Flow to Equity model (i.e. 𝑉 𝐹𝐶𝐹𝐸 .

(10 marks)

(Total 25 marks)