Paper 2.7 Investment Management

CHARTERED INSTITUTE OF STOCKBROKERS September 2018 Specialised Certification Examination Paper 2.7 Investment Management 2

Question 2 - Portfolio Management 2a) An analyst gathered the following information about a portfolio comprised of three bonds: Bond Price Par Amount Duration ( ) owned ( ) A 102.000 7 million 1.89 B 94.356 5 million 7.70 C 88.688 3 million 11.55 Estimate: 2a1) Total market value of the portfolio (2 marks) 2a2) The duration of the portfolio (2 marks) (Total: 4 marks) Solution to Question 2b 2a1) Portfolio Value: 1.02 7m = 7,140,000 0.94356 5m = 4,717,800 0.88688 x 3m = 2,660,640 Portfolio value 14,518,440 2a2) Portfolio duration 7,140,000/14,518,440 x 1.89 = 0.93 4,717,800/14,518,440 x7.7 = 2.50 2,660,640/14,518,440 x 11.55 = 2.12 Portfolio duration 5.55 (2 marks) (2 marks) Question 2b S plc. issues a debenture at par carrying a 9% coupon. The debenture is redeemable in five years and each unit of 100 is convertible into 20 ordinary shares at any time prior to redemption. At the date of issue the yield on comparable nonconvertible debenture is 12% and the company s shares are quoted at 400k. Required: Calculate the conversion premium on the debenture at the date of issue and explain in general terms the relationship between the conversion premium and the coupon rate on convertible debentures (4 marks) Solution 2b Conversion Premium But conversion price :. Conversion Premium 3

The fact that a conversion premium exists, and that the coupon rate on convertibles is frequently less than that on redeemable stocks reflects expectations of share price movements. It is expected that the share price will increase between the date of issue of the stock and the date of conversion in such a way as to mean that conversion on the due date will allow the debenture holder to obtain shares at a discount to the prevailing market price. (Total 2b: 4 marks) Question 2c) Discuss very briefly five factors that a financial manager should take into account when investing in marketable securities. (5 marks) Solution 2c) The factors that a financial manager should take into account when investing in marketable securities include: i.) Default risk. The risk that interest and/or principal will not be paid on schedule on fixed interest investments. Most short-term investment in marketable securities is confined to investments with negligible risk of default. ii.) Price risk. The risk of the value of the investment changing for example when interest rates change. Financial managers normally wish to avoid substantial price risk. iii.) Marketability. Securities should normally be marketable at short notice at close to the quoted market price. iv.) Taxation. Are there any special tax effects of the selected marketable securities? v.) Yield. Managers will usually try to achieve the maximum yield possible consistent with a satisfactory level of risk and marketability. vi.) Foreign exchange risk. If marketable securities are not denominated in the domestic currency of the investor, foreign exchange risk must be taken into account. vii.) The amount of funds to be invested. Some types of investment require a minimum size of investment. viii.) The period for which the investment is to be made. The type of investment should be matched with the timing requirements of the future need for funds. (1 mark each for any 5 points) (Total: 14 marks) Question 3 - Corporate Finance 3a) A capital investment project has the following estimated cash flows and present values: Year Cash flow Discount factor @ 12% Present value 0 Initial investment (200,000) 1.0 (200,000) 1-5 Contribution per 108,000 3.605 389,340 annum 1 5 Fixed costs per (30,000) 3.605 (108,150) annum 5 Residual value 30,000 0.567 17,010 Required: Calculate the sensitivity of the investment decision to a change in the annual contribution. 4

Solution to Question 3a Sensitivity to a change in annual contribution = NPV/PV of contribution NPV = -200,000 + 389,340 108,150 + 17,010 = 98,200 Sensitivity = 98,200/ 389,340 = 25.22% This means that the annual total contribution can drop by a maximum of 25.22% if the project is to remain viable. (Total 3a: 3 marks) 3b) List the three fundamental conditions required for the use of WACC in project appraisal. Solution to Question 3b The required conditions are: i) The amount invested on the project must be very small relative to the total value of the company. ii) The financing of the new project should not significantly alter the company s debt/equity ratio in order to hold the company s financial risk constant. iii) The new project should be an expansion of activities in the existing industry rather than a diversification into a new industry. This ensures constant business risk. (1 mark for each point) (Total Question 3: 6 marks) Question 4 Portfolio Management 4a) The managers of a pension fund follow an active portfolio management strategy. They try to purchase shares and bonds that show a positive abnormal return (positive alpha factor in the case of shares). The pension fund is required by law to hold at least 40% of its investments in bonds. 100million is currently available for investment. Three shares and three bonds are being considered for purchase. The required return on bonds may be measured using a model similar to the capital asset pricing model, where beta is replaced by the relative duration of the individual bond (D 1 ) and the bond market portfolio(d m ) i.e D 1 /D m. Shares Expected return (%) Standard Deviation Correlation coefficient of of returns returns with the markets Equity market 10.5 15 1 A plc 11.0 25 0.76 B plc 9.5 18 0.54 C plc 13.5 35 0.63 Bonds Duration (years) Coupons (%) Redemption yield (%) Bond market 7.5-5.8 Federal Govt. 1.5 8 4.5 D plc 8.6 6 5.3 E plc 14.2 9 7.2 5

The risk free rate is 4% Required: 4a1) Evaluate whether or not any of the shares or bonds are expected to offer a positive abnormal return. (10 marks) 4a2) The pension fund currently has the maximum permitted investment in shares and wishes to continue this strategy. It has a market value of 1,000 million and a beta of 0.62. Calculate the required return from the pension fund if any shares and bond with positive abnormal returns are purchased. State clearly any assumptions that you make 4a3) Discuss possible problems with the pension funds investment strategy. (5 marks) Solution to Question 4a (Total: 18 marks) 4a1) A positive abnormal return will exist if the expected return from a security is higher than the required return. This may be established by using the capital asset pricing model (CAPM). (2 marks) The betas of the individual shares may be found using. (½ mark) (½ mark) (½ mark) Using the CAPM, the required return is given by R i = R f + β i (R m - R f ) Company Expected return R i Required Return R i Alpha R i - R i % % % A plc 11 4 + 1.27(10.5-4) = 12.26-1.26 (½ mark) B plc 9.5 4 + 0.65(10.5-4) = 8.22 1.28 (½ mark) C plc 13.5 4 + 1.47(10.5 4) = 13.56-0.06 (½ mark) For the bonds the relative durations are: 6

Organisation Expected Return R i (%) Required return R i (%) Alpha R i R i (%) Fed. Govt. 4.5 4 + 0.20(5.8-4) = 4.36 0.14 D plc. 5.3 4 + 1.15(5.8-4) = 6.07-0.77 E plc. 7.2 4 + 1.89(5.8-4) = 7.40-0.20 If these data are accurate, the shares of B plc and the Federal Government bond offer a positive abnormal return. (10 marks) 4a2) The beta of the revised portfolio is the weighted average of the betas of the components of the portfolio. Investment Market Value Beta Hash total Existing portfolio 10000.62 620 Shares in B plc 600.65 39 FG bond 400.20 8 1,100 667 (½ mark each) Beta = 667/1,100 = 0.61 Required return = 4 + 0.61(10.5-4) = 7.97% (Total 4a2: 3 marks) 4a3) The active strategy relies upon the pension fund managers being able to regularly correctly identify underpriced securities. The implication is that the securities markets are not continuously efficient, and that excess returns can be earned by trading in mispriced securities. Markets are certainly not perfectly efficient, but whether or not mispriced securities can be regularly found that will lead to an abnormal return, after any administrative and transactions costs, is debatable. A policy of selecting only mispriced securities might mean that the portfolio risk and return are not consistent with the objectives of the portfolio or desire of the investment clients. The strategy is based upon using the capital asset pricing model, and presumes that the model presents an accurate measure of the required returns from securities. The CAPM, however, is based upon a number of unrealistic assumptions, such as a perfect capital market exists, borrowing and lending can take place at the risk free rate, investors have the same expectations about risk and return, investors are well diversified, and all investors consider only the same single time period. It also states that systematic risk is the only relevant measure of risk. It is likely that multifactor models such as the arbitrage pricing theory offer better explanations of the relation between risk and return. Accurate data input for elements of the CAPM such as the market return and relevant betas are difficult to estimate, and the CAPM has empirical anomalies, for example it appears to overstate the required return on high beta securities and understate the required return on low beta securities. (5 marks) (Total Question 4a: 18 marks) 7

Question 4b Smart Funds Plc (SF) has a portfolio of short-term investments in the shares of four quoted companies. Company Tinco (T) Paska (P) Binto (B) Yinte (Y) Holding 100,000 shares 155,000 shares 260,000 shares 430,000 shares You have the following additional information: Expected total return on Market value per share investment p.a. Company Beta (kobo) (%) T 1.55 280 21 P 0.65 340 12.5 B 1.26 150 18 Y 1.14 95 18.5 The market risk premium is 10% per year and the risk free rate is 6% per year. Required: 4b1) Estimate the beta of SF s short-term investment portfolio. 4b2) Recommend, giving your reasons, whether the composition of SF s short-term investment portfolio should be changed. Show relevant calculations. (Hint: consider the alpha values of the shares and the propriety of investing shortterm funds in equity) (10 marks) 4b3) Briefly explain the primary differences between the APT and the CAPM (5 marks) (Total: 18 marks) Solution 4b 4b1) The risk of SF s short-term investment portfolio may be measured by the weighted average beta of the four shares. The weighting is by the market value of the shares. Market value Beta T 280,000 1.55 434,000 P 527,000 0.65 342,550 B 390,000 1.26 491,400 Y 408,500 1.14 465,690 1,605,500 1,733,640 (1 mark each) Portfolio beta = 1,733,640/1,605,500 = 1.08 SF s short-term investment portfolio is slightly more risky than the market. (Total 4b1: 3 marks) 8

4b2) The composition of the short-term investment may be examined from two viewpoints: i.) Is the performance of the individual investments within the portfolio satisfactory? ii.) Does the portfolio provide the most suitable form of short-term investments for SF? The individual shares may be examined to establish if they are expected to provide satisfactory return for the systematic risk they involve. Using CAPM, we compute the required return of each share. T 6 + 1.55(16-6) = 21.5% P 6 + 0.65(16-6) = 12.5% B 6 + 1.26(16-6) = 18.6% Y 6 + 1.14(16-6) = 17.4% Next, we compute the expected excess return (i.e the alpha value = ) and make recommendation. Expected Required Alpha return return value % % % (a) (b) (a - b) Recommendation T 21 21.5-0.5 Over-valued, sell P 12.5 12.5 0 Properly value, hold B 18 18.6-0.6 Over-valued, sell Y 18.5 17.4 1.1 Under-valued, buy more If the above data are correct, the shares in companies T and B are not expected to give a satisfactory return relative to their systematic risk and should be sold. The shares in P should be held, and further shares should be purchased in Y. However, none of the abnormal returns are large and any decision to buy or sell might be influenced by this, as well as the existence of transaction costs. We are also assuming that the capital market is not efficient. In addition, the analysis considers only systematic risk. If SF does not have other investment and is not well diversified, systematic risk is likely to under-estimate the risk to SF of these investments. The portfolio is unusual for a short-term investment portfolio. Short-term investments are usually made for a specific purpose, for example to ensure cash is available for purchase of assets, payment of dividends, taxes or creditors where a known amount of funds is required. Most companies are not willing to tolerate much risk of price movement in their short-term investments. This portfolio of investments in ordinary shares is exposed to substantial price movements as share prices change and the possibility that one or more of the companies could fail. Although the expected returns are relatively high, the risk of this portfolio is very high relative to most portfolios of marketable securities. Unless SF is happy to take such risks it is recommended that short-term investments should concentrate upon fixed interest marketable securities such as Treasury Bills, certificates of deposit and bills of exchange. Such investments involve much less risk of price movement and default, and, if held short-term, possible inflation is not a concern. (10 marks) 4b3) The basic Capital Asset Pricing Model (CAPM) assumes that investors care only about portfolio risk and expected return; i.e., they are risk averse. From this assumption 9

comes the conclusion that a portfolio s expected return will be related to only one attribute its beta (sensitivity) relative to the broadly based market portfolio. Arbitrage Price Theory (APT) takes a different approach: it is not much concerned about investor preferences, and it assumes that returns are generated by a multi-factor model. APT reflects the fact that several major (systematic) economic factors may affect a given asset in varying degrees. Further, unlike the CAPM, whose single factor is unchanging, APT recognises that these key factors can change over time (as can investor preferences). Summarizing, APT Identifies several key systematic macroeconomic factors as part of the process that generates security returns vs. Only one factor recognised by the CAPM, Recognises that these key factors can change over time, whereas the capm s single factor is unchanging, Makes fewer assumptions about investor preferences than the capm, and Recognises that these preferences can change over time. (1 mark for any 3points) (Total 4b3: 5 marks) Question 5 - Corporate Finance 5a) The following financial information is available for PH Plc. 2014 2015 2016 2017 Earnings attributed to ordinary shareholder 200m 225m 205m 230m Number of ordinary shares 2,000m 2,100m 2,100m 1,900m Price per share (kobo) 220 305 290 260 Dividend per share (kobo) 5 7 8 8 Assume that share prices are as at the last day of each year. Required: 5a1) Calculate PH plc s earnings per share, dividend yield, dividend cover and price/earnings ratio. Explain the meaning of each of these terms and why investors use them, and what limitations they may have. (6 marks) 5a2) Explain why the changes that occurred in the figures calculated in (a) above over the past four years might have happened. (Total: 9 marks) Solution to Question 5a 5a1) Data: 2014 2015 2016 2017 1 Equity earnings ( m) 200 225 205 230 2 Number of shares (m) 2,000 2,100 2,100 1,900 3 Price per share (kobo) 220 305 290 260 4 Dividend per share (kobo) 5 7 8 8 5 Earnings per share (= 1 2)(kobo) 10 10.7 9.8 12.1 Dividend yield (= 4 3) 2.3% 2.30% 2.80% 3.1% Dividend cover (= 5 4) 2.0 1.5 1.2 1.5 times Price/earnings ratio (= 3 5) 22.0 28.5 29.6 21.5 times (½ mark each) 10

Earnings per share Earnings per share (EPS) shows the amount of profit after tax attributable to each ordinary share. Although a high EPS generally indicates success, care must be taken in interpreting the trend in EPS when there have been share issues, especially rights issues at heavily discounted prices or bonus issues, both of which result in a fall in EPS. Similar problems are encountered when warrants or convertible loan notes are issued. Dividend yield The dividend yield shows the ordinary dividend as a rate of return on the share value. The figure is of limited use because it shows only part of the return to the equity investor. Price/Earnings ratio The price/earnings ratio (P/E ratio) shows how many times bigger the share price is than the EPS. In general, the bigger the EPS, the more the share is in demand, though care must be taken when making comparisons because whereas EPS is a historical result, the share price is based on future expectations and is affected by both risk and growth factors. Consequently, abnormal results can often arise from a crude use of P/E ratios. (½ mark each for the explanation. Total: 3 marks) 5a2) Trends in 2015 In 2015, share capital was increased by 5%, probably through a rights issue. Equity earnings increased more than proportionately, resulting in a 7% increase in EPS, indicating a successful year. Demand for the company s share rose swiftly, either because of a general stock market rise or because of high expectations of PH plc s future growth, and the share price rose by approximately 40%. This caused a big rise in P/E and allowed a 40% increase in dividend per share with no fall in dividend yield. The dividend cover fell, however, because the dividend increased much more than earnings. (2 marks) Trends in 2016 The company s earnings and EPS fell in 2016, either because of normal cyclical business risks or possibly because the high 2015 dividend left insufficient cash for reinvestment. However, the company gave a bullish signal to the market by increasing its dividend per share, indicating future prospects of a swift recovery and increased growth. As a result, the dividend yield increased and, although the share price fell in line with earnings, there was no disproportionate drop in demand for the company s shares, as shown by the stability of the P/E. (2 marks) Trends in 2017 There was 12% earnings growth in 2017. The company used some of its cash to buy back ordinary shares. This is possibly because it offered shareholders the choice between a cash and a scrip dividend. Share capital reduced by about 10%, resulting in a big increase in earnings per share. Although 2017 was a successful year for earnings, demand for the company's shares fell, as shown by the drop in share price and P/E. It is possible that the market has become uncertain of the company's future plans, as a result of the share issue and share buy-back in quick succession. (2 marks) (Total 5a: 9 marks) Question 5b One of your very important clients works with a highly respected private company in kano. He is due for retirement in 10 years. At the point of his retirement, it is projected that the balance of his mortgage will be 23,078,999. He plans to pay off the mortgage on retirement. 11

To fund the payment, he has been investing on series of zero-coupon bonds each with face value of 3,000,000. Five different bonds are involved. The bonds are designed to mature at interval of every 2 years commencing from the end of 2nd year for the next 10 years (total of 5 receipts). Assume that the market yield for all instruments and for all maturities is 10% p.a. 5b1) Explain very carefully why zero-coupon bond is often considered an ideal financial instrument for immunizing a future liability. 5b2) Calculate the present value of the given assets and liability of your client. What is the net surplus today? (5 marks) Solution 5b 5b1) The objective of immunisation centres around mitigating the two components of interest rate risk price risk and coupon reinvestment risk. Keeping this in mind, many feel that zero coupon bond is the ideal financial instrument to use for immunisation because it eliminates these risks, and thus eliminates the need to rebalance the portfolio. Reinvestment risk is eliminated because there are no intervening cash flows to reinvest, and price risk is eliminated because if you set the duration equal to your time horizon, you will receive the face value of your bond at maturity. 5b2) PV of Assets The cash flows expected from the zero coupon bonds are Yr CF ( ) 2 3,000,000 4 3,000,000 6 3,000,000 8 3,000,000 10 3,000,000 A very fast way of doing the discounting is to use annuity. This however demand the use of 2 yearly discount rate: 2 yearly rate: (1.10) 2 1 = 21% The annuity formula is then used: 1-1.21) -5* 3,000,000 = 8,777,953 0.21 (* 5 period of two years each) Alternative Method 3,000,000 3,000,000 3,000,000 3,000,000 3,000,000 PV = + + + + = 8,777,953 (1.10) 2 (1.10) 4 (1.10) 6 (1.10) 8 (1.10) 10 12

PV of Liability This is given by 23,078,999(1.10)-10 = 8,897,953 OR 23,078,999(1.21)-5 = 8,977,953 Surplus Surplus = PVA PVL = 8,777,953 8,977,953 = 200,000. (2 marks) (Total 5b: 5 marks) 5c) Two companies, Akin Plc and Pawpaw Plc, have recently merged. The prime mover of the merger was Akin Plc with a beta factor of 1.5 and a market capitalization of N20,000,000 just before the merger. Pawpaw Plc is smaller, and had a market capitalization of N10,000,000 and a beta factor of 0.6 just before the merger. Both companies were all equity financed at the time of the merger and were fairly valued by the market. The two companies were in different industrial sectors and displayed very little co-movement in their earnings streams. While no economies of scale or other synergistic benefits were available from the merger, the management of Akin Plc strongly favoured proceeding with the merger in order to achieve a lower risk profile for the combined firm. Shares in the combined entity were distributed on the basis of the total market values of the individual companies just before the merger. The expected return on the market before and after the merger was 13% per annum and the return on the risks free security was similarly constant at 8% per annum. Required: Calculate the expected return on the securities both before and after the merger using the capital asset pricing model. Solution 5c Expected returns using the capital asset pricing model According to the capital asset pricing model, the expected return on a quoted security is given by r f + (r m - r f )β Where: r f is the return on the risk free security r m is the expected return on the stock market β is the beta factor for the security Expected returns before merger Akin: Shares in Akin Plc: 8% + (13% - 8%) 1.5 = 15.5% (½ mark) Pawpaw: Shares in Pawpaw Plc: 8% + (13% - 8%) 0.6 = 11% (½ mark) Expected return after the merger After the merger, in proportions 2:1, the β factor of the combined firm will be equal to the weighted average of the βs in the two original firms, i.e.: (⅔ x 1.5) + (⅓ x 0.6) = 12 13

Expected return after the merger 8% + (13% - 8%) 1.2 = 14% (Total 5c: 3 marks) (Total Question 5: 20 marks) 14