Examiners’ commentaries 2015

Examiners’ commentaries 2015

AC3143 Valuation and securities analysis

Important note

This commentary reflects the examination and assessment arrangements for this course in the
academic year 2014–15. The format and structure of the examination may change in future years,
and any such changes will be publicised on the virtual learning environment (VLE).

Information about the subject guide and the Essential reading

references

Unless otherwise stated, all cross-references will be to the latest version of the subject guide (2013).
You should always attempt to use the most recent edition of any Essential reading textbook, even if
the commentary and/or online reading list and/or subject guide refer to an earlier edition. If
different editions of Essential reading are listed, please check the VLE for reading supplements – if
none are available, please use the contents list and index of the new edition to find the relevant
section.

General remarks

Learning outcomes

At the end of this course, and having completed the Essential reading and activities, you should be
able to:

• carefully analyse the financial performance of given securities and critically review equity
research published by financial analysts
• competently apply valuation technologies required in corporate finance with minimum
guidance
• critically assess third-party valuation reports
• recall main insights and key facts of the fund management industry
• clearly recognise the difficulties associated with measuring abnormal returns in fundamental
and technical analysis.

Planning your time in the examination

The examination paper clearly states the number of questions that candidates should answer from
each section of the examination. Each question carries 25 marks. Candidates should be able to
identify the importance of the subsection of each question by the number of marks allocated to it. It
is recommended that candidates look at all subsections of a given question before answering a
particular subsection so that they have an overall idea of how many subsections there are and how
much time should be allocated to each of them.

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AC3143 Valuation and securities analysis

What are the examiners looking for?

The examiners expect candidates to show their ability to understand the question as it appears in
the examination paper. It is very important that candidates answer all questions only to the extent
that they are asked. Any vaguely related information to the question asked will not be considered as
a correct answer. Therefore, candidates should be careful to provide only relevant points and not to
engage in irrelevant digressions. Doing so will ensure that candidates have enough time to earn
maximum points for the number of questions that they have attempted.

Key steps to improvement

Given the large amount of material covered in this course, it is very important that candidates have
a structured approach to studying every topic. A good first step would be to read thoroughly on a
given topic covering all the sources available. Reading from various sources (textbooks, the subject
guide, etc.) will help candidates acquire a comprehensive understanding of the topic. They should
ensure that they understand all the numerical computations involved. Reading the solution to a
given question does not test candidates understanding of this question in the same way as working
through the answer on your own does.

Another crucial step in studying a given topic is to test your understanding. This can be done by
working through the questions that are set at the end of each topic.

The final step would be to attempt past examination questions. These will not only test your
knowledge on a given topic but also improve your ability to draw links between various topics
covered in the course.

A note on Examiners’ commentaries

Candidates may find the Examiners’ commentaries useful in preparing for the examination. The
commentaries do not provide specific answers to questions but are intended to help candidates work
out a structured approach to addressing a question. Their purpose is not to limit candidates to the
approach suggested but to illustrate the scope and depth of an appropriate answer to a given
question.

Examination revision strategy

Many candidates are disappointed to find that their examination performance is poorer than they
expected. This may be due to a number of reasons. The Examiners’ commentaries suggest ways of
addressing common problems and improving your performance. One particular failing is ‘question
spotting’, that is, confining your examination preparation to a few questions and/or topics which
have come up in past papers for the course. This can have serious consequences.

We recognise that candidates may not cover all topics in the syllabus in the same depth, but you
need to be aware that examiners are free to set questions on any aspect of the syllabus. This
means that you need to study enough of the syllabus to enable you to answer the required number of
examination questions.

The syllabus can be found in the Course information sheet in the section of the VLE dedicated to
each course. You should read the syllabus carefully and ensure that you cover sufficient material in
preparation for the examination. Examiners will vary the topics and questions from year to year and
may well set questions that have not appeared in past papers. Examination papers may legitimately
include questions on any topic in the syllabus. So, although past papers can be helpful during your

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 Examiners’ commentaries 2015

revision, you cannot assume that topics or specific questions that have come up in past examinations
will occur again.

If you rely on a question-spotting strategy, it is likely you will find yourself in difficulties
when you sit the examination. We strongly advise you not to adopt this strategy.

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AC3143 Valuation and securities analysis

Examiners’ commentaries 2015

AC3143 Valuation and securities analysis

Important note

This commentary reflects the examination and assessment arrangements for this course in the
academic year 2014–15. The format and structure of the examination may change in future years,
and any such changes will be publicised on the virtual learning environment (VLE).

Information about the subject guide and the Essential reading

references

Unless otherwise stated, all cross-references will be to the latest version of the subject guide (2013).
You should always attempt to use the most recent edition of any Essential reading textbook, even if
the commentary and/or online reading list and/or subject guide refer to an earlier edition. If
different editions of Essential reading are listed, please check the VLE for reading supplements – if
none are available, please use the contents list and index of the new edition to find the relevant
section.

Comments on specific questions – Zone A

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

Section A

Answer one question and no more than two further questions from this section.

Question 1

The reformulated balance sheet of Philharmonia plc is as follows (values in millions

of pounds).

2013 2014
Intangible assets 6,750 8,125
Property, plant and equipment 4,500 6,750
Inventory 3,075 4,613
Operating obligations 4,425 6,638
Interest-bearing debt 3,450 5,175
Called up share capital 2,250 3,375
Share premium 2,310 2,800
Retained earnings 1,890 1,500

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 Examiners’ commentaries 2015

The following is an extract from Philharmonia’s reformulated income statement:

2014
Net sales 7,054
Other operating expenses 2,386
Depreciation 1,314
Net financial expense 300

Required:

(a) Calculate the free cash flow (FCF) of Philharmonia plc for the year 2014.
[6 marks]

Reading for this question

This question requires calculation of Free Cash Flow. The calculation of free cash flow is
covered under securities analysis section of the subject guide. It is also explained in Chapter
4 (Cash Accounting, Accrual Accounting and Discounted Cash Flow Valuation) of Penman
textbook and Chapters 7 (Prospective Analysis: Valuation Theory and Concepts) and 8
(Prospective Analysis: Value Implementation) of Healy and Palepu textbook.
Approaching the question
Based on the given information above, the calculation of FCF as the difference between
operating income and net operating assets is quite straightforward. Operating income is
calculated from the information given in the income statement of Philharmonia plc and the
changes in net operating assets are calculated based on the values of the operating assets in
years 2011 and 2012. These are taken from the balance sheet of Philharmonia plc.
FCF = Operating Income − Change in net operating assets.
Operating Income = 7,054 − 2,386 − 1,314 = 3,354.
Net operating assets (2014) = 8,125 + 6,750 +4,613 − 6,638 = 12,850.
Net operating assets (2013) = 9,900.
Change in net operating assets = 2,950.
FCF = 3,354 − 2,950 = 404.

(b) For the year 2014, Philharmonia’s cost of equity is 8%, cost of debt is 6% and
the tax rate is 10%. Calculate its weighted average cost of capital (WACC) for
this year. Assume that the market values of debt and equity are equal to their
book values.
[4 marks]

Reading for this question

This question requires candidates’ understanding of weighted average cost of capital. A
discussion of the cost of capital and the formula for its calculation can be found in Chapter
8 (Securities Valuation) of the subject guide.
Approaching the question
The cost of equity can be derived from the WACC formula, which requires knowledge of the
market values of debt and equity. Since these are not available, the stated assumption that
market values of debt and equity are equal to their book values implies that the book values
of debt and equity should be used in the formula. Candidates should bear in mind that only
interest-bearing debt is relevant for the calculation of WACC. Therefore, the operating
obligations are not relevant for the calculation of WACC. After working out the proportions
of debt and equity (based on their book values), the cost of equity can be inferred as the
only unknown variable in the WACC formula.
WACC = V E /(V E + V D ) × rE + V D /(V E + V D ) × rD × (1 − τ ).
WACC = 0.33 × 8% + 0.67 × 6% × (1 − 0.1) = 6.25%.

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AC3143 Valuation and securities analysis

(c) Under the competitive equilibrium assumption the terminal value in the
discounted cash flow model is the present value of the end-of-year book value of
equity in the terminal year. Explain.
[5 marks]

Reading for this question

Penman, Chapter 5 (Accrual Accounting and Valuation: Pricing Book Values) provides a
discussion of terminal (also known as continuing) value assumptions and calculations.

Approaching the question

In calculating terminal values, investors usually have to make an assumption about the
growth and competitive advantage of the company after the period of the last explicit
forecast until infinity (or until the firm exists). These assumptions are usually that the
company will grow at a constant rate or that the company will generate the same level of
cash flows for ever. In answering this question candidates should think about the
implications of each of the two scenarios. Growing at a constant rate implies that the
company will continue to identify investment opportunities that generate abnormal profits.
Growing at zero rate implies that competition will limit the ability of the company to
generate abnormal profits.

(d) Discuss the limitations of the Present Value of Discounted Free Cash Flow
(PVDCF) method.
[5 marks]

Reading for this question

Chapter 8 of the subject guide (Securities Valuation).

Approaching the question

An excellent answer to this question will discuss the limitations of the PVDCF method
along the following lines: Is FCF, on which the PVDCF model is based, a good indicator of
profitability and why? Is FCF a good indicator of PE and PB ratios and why? Does
PVFCF work in all cases? Is PVFCF used by professional analysts?

(e) Explain why terminal values in accounting-based valuation are significantly less
than those for DCF valuation.
[5 marks]

Reading for this question

Same as in (c).

Approaching the question

DCF terminal values include the present value of all expected cash flows beyond the forecast
horizon. Note that the expected cash flows beyond the forecast horizon can be broken down
into two parts: normal and abnormal. Since the terminal value in the accounting-based
technique includes only the abnormal earnings (expected earnings minus cost of capital
times beginning book value of equity), the terminal values in accounting-based valuation are
significantly less than those for DCF valuation. The accounting-based approach recognises
that current book value and earnings within the forecast horizon already reflect many of the
cash flows expected to arrive after the forecast horizon.

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 Examiners’ commentaries 2015

Question 2

Answer all parts of this question:

(a) New Pharma Ltd announces £10 million rise in profits. Is its stock price going
to rise? Explain.
[10 marks]

Reading for this question

To answer this question, candidates need to understand the link between accounting
information (i.e. earnings) and stock prices. They need to refer to the empirical evidence on
this issue (e.g. Ball and Brown 1968), which can be found in Chapter 9 of the subject guide.

Approaching the question

Candidates should first discuss the usefulness of accounting information to capital markets
as documented by Ball and Brown (1968). They should refer to the magnitude of the
association between accounting information and market prices and its dependence on the
level of investors’ expectations before the earnings announcement. Since the question does
not give any information about investors’ expectations for the profits of New Pharma Ltd,
candidates need to condition their answer on the level of market/investor expectations.
An excellent answer to this question will also refer to the empirical literature on the
magnitude of the earnings response coefficient (e.g. Easton and Zmijewski, 1989; Kormendi
and Lipe, 1987; Ali and Zarowin, 1992).

(b) Assume New Medicine Ltd is an identical company to New Pharma Ltd. The
only difference between the two companies is that New Medicine Ltd capitalises
its Research and Development (R&D) investments whereas New Pharma Ltd
expenses them. In the same period when New Pharma Ltd announces
£10million increase in earnings, New Medicine Ltd announces £16 million
increase in earnings. How will the price of New Medicine Ltd change relative to
the price of New Pharma Ltd?
[8 marks]

Reading for this question

This question requires candidates to make a link between two different topics covered in the
syllabus: accounting analysis, covered in Chapter 3 of Palepu, Healy and Bernard and
Chapter 2 of Penman, and empirical evidence on the link between accounting information
and stock prices, covered in Chapter 9 of the subject guide.

Approaching the question

When answering this question it is important to first understand the factors that cause
changes in a firm’s stock price. Since the stock price is derived from the discounted value of
future cash flows (from the DCF model) anything that changes the expected future cash
flows will have an effect of the stock price. Therefore, candidates should first try to answer
the question whether a change in accounting policy with no underlying change in economic
reality will affect the future expected cash flows of a firm.

(c) Critically assess how accounting analysis may improve accounting-based

valuations.
[7 marks]

Reading for this question

Same as in part (b).

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AC3143 Valuation and securities analysis

Approaching the question

The obvious answer to this question is yes although there are many ways to justify it. One
may argue that accounting analysis may enable an analyst to get better estimates of future
residual earnings through better estimates of persistence in residual earnings. A very good
answer will include examples. An excellent answer will quote Lev and Thiagarajan (1993) or
Sloan (1996).

Question 3

The following are summaries of financial statements for Homefield plc for fiscal year
ending January 31, 2014

Summary Reformulated Balance Sheet, January 31, 2014

(in millions of pounds)

2014 2013 2014 2013

Financial liabilities 4,085 2,159
Financial assets 757 456 Operating liabilities 13,488 12,703
Operating assets 43,725 38,564 Common equity 26,909 24,158
(on 2,336 million
outstanding shares)
44,482 39,020 44,482 39,020

Summary Reformulated Income statement for the year ended, January 31, 2014
(in millions of pounds)

Sales 81,511
Core operating expenses 72,148
Core operating income 9,363
Taxes allocated to core operating 3,474
income
Core operating income, after tax 5,889
Unsustainable operating income, 182
after tax
Operating income, after tax 6,071

Required:

Wherever is relevant, refer to the beginning-of-period balance sheet figures for all
calculations in the questions below.

(a) Calculate the following from these statements:

1. Financial leverage.
[2 marks]
2. Operating liability leverage.
[2 marks]
(b) Homefield estimates that it pays an implicit after-tax borrowing cost on its
operating liabilities of 2% after tax. Calculate the rate of return it would have
earned from its operations had it not used this financing.
[2 marks]
(c) Calculate the return on net operating assets (RNOA) for 2014. Also calculate
the core return on net operating assets (NOA) for 2014.
[4 marks]

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 Examiners’ commentaries 2015

(d) The firm has a net borrowing cost of 3.0% after tax. Calculate the return on
common equity (ROCE) for 2014.
[2 marks]
(e) Complete the income statement to report the after-tax net financial expenses
for 2014 and comprehensive income.
[2 marks]
(f ) An analyst argues that Homefield should borrow £17,000 million to repurchase
its equity stock. Suppose the core operating profitability and the net borrowing
cost were forecasted to be the same for 2015 as in 2014. What return on
common equity (ROCE) would you forecast for 2015 under the following
conditions:
1. Homefield did not make the stock repurchase.
2. Homefield made the stock repurchase on January 31, 2014.
[4 marks]
(g) Explain whether a company can grow faster than its sustainable growth rate.
[7 marks]

Reading for this question

Chapter 5 of Healy and Palepu.

Approaching the question

(a) 1. Financial leverage.

FLEV = NFO/CSF = 1,703/24,158 = 0.0705.
NFO = 2,159 − 456 = 1,703.
2. Operating liability leverage.
OLLEV = 12,703/25,861 = 0.4912.
(b) ROOA = (OI + Implicit interest)/OA = ( 6,071 + (0.02×12,703))/38,564 = 16.40%.
(c) RNOA = 6,071/25,861 = 23.48%.
Core RNOA = 5,889/25,861 = 22.77%.
Note: RNOA = ROOA + [OLLEV * (RNOA + Implicit borrowing cost)].
23.48% = 16.40% + [0.4912 ×(16.40% − 2.0%)].
(d) ROE = RNOA + [FLEV + (RNOA − NBC)] = 23.48% + [0.0705×(23.48% − 3.0%)] =
24.92%.
(e) Operating income, after tax = 6,071.
Net financial expense, after tax = 51 (1,703 ×0.03).
Comprehensive income = 6,020.
Note: ROE = 6,020/24,152 = 24.92%.
(f) FLEV = NFO/CSE = 3,328/26,909 = 0.1237.
ROE 2017 = 22.77% + [0.1237×(22.77% - 3.0%)] = 25.22%.
With stock repurchase:
NFO = 3,328 + 17,000 = 20,328.
CSE = 26,909 -17,000 = 9,909.
FLEV = 20,328/9,909 = 2.0515.
ROE 2015 = 22.77% + [2.0515 ×(22.77% - 3.0%)] = 63.33%.

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AC3143 Valuation and securities analysis

(g) A good answer will start with pointing out that the sustainable growth rate is the speed at
which a company can expand without changing either its level of profitability or its financial
policies. Mechanically, sustainable growth rate = ROE × (1 − dividend payout ratio). From
this equation, we see that ROE and the dividend payout ratio determine the funds
remaining in the firm and available to finance the firms growth. If a company wants to
exceed its sustainable growth rate, it can increase its return on equity by improving its
profitability (return on sales), increasing its asset turnover, or increasing leverage.
Alternatively, it can reduce its dividend payout rate, thereby increasing funds available for
reinvestment. So, an excellent answer will conclude that the statement is false after
providing the above arguments.

Question 4

The summarised balance sheets of Madelene Ltd are as follows (values in millions of
pounds):

2013 2014
£’m £’m
Net operating assets 52,500 61,500
Financial assets 10,050 11,100
Financial obligations 28,050 31,950
Common shareholders’ equity 34,500 40,650

In 2014 operating income is £8,400 (million) and the forecast growth rate of net
operating assets is 3%.

Required:

(a) Assuming that the weighted average cost of capital for the firm (WACC) =
9.5%, use Forecasting from Book Values (SF1 Forecasting), Forecasting from
Earnings and Book Values (SF2 Forecasting) and Forecasting from Accounting
Rates of Return (SF3 Forecasting) to estimate the value of Net Operating
Assets (NOA) in the year 2014.
[7 marks]

(b) Explain under which conditions the 3 methods in (a) would be applicable for
estimating NOA.
[8 marks]

(c) How does simple forecasting differ from full forecasting?

[4 marks]

(d) What is the difference between SF1 and SF2 forecasts? What is the difference
between SF2 and SF3 forecasts?
[6 marks]

Reading for this question

This question tests candidates’ understanding of simple forecasting methods. The background
reading for this question can be found in Chapter 7 of the subject guide (Prospective
Performance Evaluation and Valuation) and Chapters 14 (Anchoring the Financial Statements:
Simple Forecasting and Simple Valuation) and 15 (Full Information Forecasting: Valuation and
Business Strategy Analysis) in Penman.

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 Examiners’ commentaries 2015

Approaching the question

(a) This question should be approached by first calculating the value of net operating assets
under each of the three simple forecasting methods:
SF1: Value of NOA = Value of the firm = NOA2012 .
SF2: Value of NOA = Value of the firm = NOA2012 + (OI2012 − rf × NOA2011 )/rf .
SF3: Value of NOA = Value of the firm = NOA2012 × (RNOA2012 − g)/(rf − g) where:
RNOA2012 = OI2012 /NOA2011 .
(b) A good answer would continue with a discussion of what types of activities and firms each of
these methods is appropriate for. An excellent answer would include a discussion of how
SF1, SF2 and SF3 values compare to each other.
(c) A good answer would mention that simple forecasts are quick approximations, but they
serve as a starting point to full information forecasts. They ensure simplicity at the expense
of accuracy. An excellent answer would then go on to describe what simple and full forecasts
are based upon. More particularly, simple forecasting is based on historical (current and
past) financial statements. Simple forecasts embed all the concepts needed for forecasting,
but they use fewer factors to make the forecasts, and also take into account no information
outside the financial statements (e.g. macroeconomic conditions, industry, etc.). Full
information forecasting instead takes into account the full set of factors that drives business
profitability and growth, and is based both on information from the financial statements and
on information outside the financial statements.
(d) One way to approach this question is to discuss first the assumptions embedded in each type
of simple forecasting. More particularly, what is the assumption about abnormal earnings
growth under SF1, SF2 and SF3 forecasts? What part of financial statements is each of the
simple forecasts based on? Excellent answers would make references to formulas, industry or
company examples.

Question 5

The following information is available for Bellwether Ltd:

Year Opening Book Value of Equity Net Income Dividends Cost of equity
2014 £600m £200m £60m 12%

Required:

(a) Assuming clean surplus accounting (i.e. that the equity changes apart from
capital transactions flow through the income statement), calculate abnormal
earnings for 2014.
[4 marks]
(b) Calculate the value of Bellwether Ltds equity at the beginning of 2014 and 2015
using the Present Value of Abnormal Earnings (PVAE) model. Assume that
both net income and dividends will grow each year until 2017 inclusive. Net
income will grow at a constant rate of 15%, and dividends will grow at a
constant rate of 10%. Dividends are paid at the year-end, and the cost of equity
does not change. The firm terminates its operations at the end of 2017.
[12 marks]
(c) One of the analysts following Bellwether says she is uncomfortable making the
assumption that Bellwether’s dividend payout will vary from year to year. If
she makes a constant dividend payout assumption, what changes does she have
to make in her other valuation assumptions to make them internally consistent
with each other?
[5 marks]

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AC3143 Valuation and securities analysis

(d) Why are the proportions of terminal values to total estimated values of equity
under the abnormal earnings method, the abnormal earnings growth method
and the discounted cash flow method different?
[4 marks]

Reading for this question

For (a), this question tests candidates’ understanding of abnormal earnings and the clean surplus
accounting concept. A discussion of abnormal earnings can be found in Chapter 7 of the subject
guide, Chapter 7 of Healy and Palepu and also Chapter 5 of Penman.

For (b), this question tests candidates’ understanding of the PVAE valuation model. A
discussion and illustration of the PVAE valuation model can be found in Chapter 7 of the
subject guide, Chapter 7 of Healy and Palepu and also Chapter 5 of Penman.

For (c) and (d), same as in (a).

Approaching the question

(a) Abnormal earnings:

AE = NI − re × BVE0 where NI is net income, re is cost of capital and BVE0 is book value
of equity.
(b) The starting point to answering this question is to apply the growth rate to current
dividends and net income in order to calculate future dividends and future net income:
DIV2015 = 1.1 × 60 = 66.
DIV2016 = 1.1 × 66 = 73.
DIV2017 = 1.1 × 73 = 80.
NI2015 = 1.15 × 200 = 230.
NI2016 = 1.15 × 230 = 265.
NI2017 = 1.15 × 265 = 304.
Equity value = BVE0 + (NI1 − re × BVE0 )/(1 + re ) + (NI2 − re × BVE1 )/(1 + re )2 + · · · .
(c) A good answer would argue as follows: if Nancy Smith doesn’t want to allow dividend
payout to vary across the years, then she can hold the dividend payout constant. However,
then she will have to allow for the capital structure to vary from year to year, since a
constant dividend payout may not result in a stream of equity values that will result in a
constant debt to equity ratio. If the capital structure is allowed to vary, then the cost of
capital will vary each period as well.
(d) The abnormal earnings method begins with the book value (which represents in some sense
‘normal earnings’) and adds to it abnormal earnings over time. The terminal value in this
method, therefore, represents the present value of only that portion of earnings that are
above the cost of capital. The discounted cash flow method, in contrast, ignores book value
completely. Instead, it captures the present value of total cash flows – both normal and
abnormal. Therefore, the terminal value in this method is significantly larger than the
terminal value in accounting based valuation approaches. In essence, part of the terminal
value in DCF is substituted by the book value in accounting-based valuation.

Question 6

Answer all parts of this question:

(a) What are the critical drivers of industry profitability?

[10 marks]

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 Examiners’ commentaries 2015

(b) A finance student states: “I don’t understand why anyone pays any attention to
accounting earnings numbers, given that a ‘clean’ number like cash from
operations is readily available.” Do you agree? Why or why not?
[7 marks]
(c) Which of the following types of firms do you expect to have particularly high or
low sales margins? Why?
a. Supermarket
b. Pharmaceutical company
c. Jewellery retailer
d. Software company
[8 marks]

Reading for this question

For (a), Chapter 2 of Healy and Palepu.

For (b), Chapter 3 and Chapter 4 of Healy and Palepu.

For (c), the reading for this question can be found in Chapter 5 of Healy and Palepu and
Chapter 4 of the subject guide.

Approaching the question

(a) • How does rivalry among existing firms affect profitability and what factors influence
existing firm rivalry?
• How does threat of new entrants affect industry profits and what factors mitigate the
threat of new entry?
• How does the threat of substitute products affect industry profitability an what does the
importance of substitutes depend on?
• How is the bargaining power of buyers linked to industry profitability and what is the
bargaining power of buyers determined by?
• How does the bargaining power of suppliers affect industry profitability? What factors
make suppliers’ bargaining ability to increase / decrease?
(b) This question tests candidates’ understanding of accrual accounting. Factors that can be
discussed in a good answer include:
• What is accrual accounting?
• Why is accrual accounting needed?
• When are cash flows from operations likely to over- or under-state the profit earning
ability of the firm? (examples)
(c) The level of sales margins should be linked to the type of product (e.g. necessity versus
luxury goods), type of firm strategy (cost versus differentiation advantage), cost basis, etc.

Section B

Answer one question and no more than two further questions from this section.

Question 7

Answer both parts of this question:

(a) What are the characteristics of Internet stocks that influence their valuation?
Explain.
[10 marks]

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AC3143 Valuation and securities analysis

(b) Is there any difference in the relative importance of financial and non-financial
information before and after the dot.com bubble? Explain.
[15 marks]

Reading for this question

This question addresses the application of valuation analysis with regard to Internet stocks. This
is discussed in Chapter 10 of the subject guide.

Approaching the question

(a) Describe the nature of the Internet firms and why it may be difficult to value them.
(b) This question should be approached by first discussing the empirical evidence by Trueman,
Wong and Zhang (2000) on the relative importance of financial and non-financial
information in the pre-Internet peak period. It should be followed by a discussion of the
empirical evidence by Keating, Lys and Magee (2003) for the post-peak period. An excellent
answer to this question will refer to the findings of Hand (2000 and 2001) and discuss how
these findings reconcile the different results documented for the pre- and post- Internet peak
periods.

Question 8

Answer both parts of this question:

(a) What are the determinants of analysts’ bias? Explain.

[15 marks]
(b) What empirical evidence of bias is there in analysts’ forecasts? Explain.
[10 marks]

Reading for this question

This question tests candidates’ understanding of the role of analysts as important capital market
intermediaries. Financial analysts’ expectations and forecasts are used as proxies for the market’s
expectations about firms’ performance. The empirical evidence on analysts’ role as information
intermediaries is discussed in Chapters 9 to 12 of the subject guide.

Approaching the question

(a) Approach this question by stating any evidence of analysts’ optimism and whether there
have been any shifts/ changes in this optimism over time.
(b) One way to approach this question is to link the determinants of analyst’s bias to the
various analysts’ incentives, including compensation, access to information, presence of
earnings skewness. An excellent answer to this question will refer to cognitive-based as well
as incentive-based explanations of bias.

Question 9

Answer both parts of this question:

(a) How can one exploit mispricing in the capital markets in the context of IPOs?
[12 marks]

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 Examiners’ commentaries 2015

(b) How do glamour stocks differ from value stocks?

[13 marks]

Reading for this question

Chapter 11 of the subject guide.

Approaching the question

(a) Discuss relevant evidence by Teoh, Welch and Wong (1998) on opportunistic earnings
management via high accruals in the year prior to the IPO.
(b) Discuss relevant evidence by Lakonishok, Schleifer and Vishny (1994) and DeBondt and
Thaler (1985).

Question 10

Answer both parts of this question:

(a) Explain the framework for the valuation of an M&A operation.

[10 marks]
(b) Critically evaluate the empirical evidence on the effects of M&A operations on
the market prices of the target and acquiring companies.
[15 marks]

Reading for this question

This question addresses the application of valuation analysis with regard to mergers and
acquisitions. This is discussed in Chapter 10 of the subject guide.

Approaching the question

(a) This question should be approached by explaining the steps of the valuation process – the
valuation of the target, synergies, added premiums, etc. This should be followed by a
discussion of any issues, complications, etc. that should be taken into consideration during
the valuation process. In particular, why the market value of the target may differ from the
intrinsic value of the firm valued as a stand alone entity? With regard to the valuation of
the synergies, what is the effect of the synergy form on the forecasts and also what is the
valuation significance of the horizon over which the synergies are expected to materialise?
(b) Discuss the magnitude of returns to target and acquiring companies’ market prices by
distinguishing between successful and unsuccessful offers. An excellent answer would discuss
how these returns have changed over time and the magnitude of the value creation for the
combined entities.

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AC3143 Valuation and securities analysis

Examiners’ commentaries 2015

AC3143 Valuation and securities analysis

Important note

This commentary reflects the examination and assessment arrangements for this course in the
academic year 2014–15. The format and structure of the examination may change in future years,
and any such changes will be publicised on the virtual learning environment (VLE).

Information about the subject guide and the Essential reading

references

Unless otherwise stated, all cross-references will be to the latest version of the subject guide (2013).
You should always attempt to use the most recent edition of any Essential reading textbook, even if
the commentary and/or online reading list and/or subject guide refer to an earlier edition. If
different editions of Essential reading are listed, please check the VLE for reading supplements – if
none are available, please use the contents list and index of the new edition to find the relevant
section.

Comments on specific questions – Zone B

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

Section A

Answer one question and no more than two further questions from this section.

Question 1

Answer all parts of this question:

At the end of the financial year ending June 30, 2013, Microsystems reported
common equity of £64.9 billion on its balance sheet, with £49.0 billion invested in
financial assets (in the form of cash equivalents and short term investments) and no
financing debt. For financial year 2014, the firm reported £7.4 billion in
comprehensive income, of which £1.1 billion was after-tax earnings on the financial
assets.

In July 2014 Microsystems distributed £34 billion of financial assets to shareholders

in the form of a special dividend.

Required:

(a) Calculate Microsystems’ return on common equity (ROCE) for 2014.

[3 marks]

16
 Examiners’ commentaries 2015

(b) Holding all else constant what would Microsystems’ ROCE be after the
dividend payout of £34 billion?
[6 marks]
(c) Would you expect the dividend payout to increase or decrease earnings growth
in the future? Why?
[3 marks]
(d) What effect would you expect the dividend payout to have on the value of a
Microsystems’ share?
[3 marks]
(e) Explain and discuss the link between a firms Return on Common Equity
(ROCE) and its Return on Net Operating Assets (RNOA).
[10 marks]

Reading for this question

Chapter 5 of Healy and Palepu.

Approaching the question

(a) ROCE = Comprehensive Income/Common equity.

(b) Income statement after payout.
OI (Comprehensive income − after-tax earnings on the financial assets).
NFI (NFA × Rate of return) (NFA = Financial assets − Dividend payout), (Rate of return
= Dividend payout/Financial).
Comp. income = OI + NFI.
CSE = Common equity − Financial assets.
ROCE = Comp. income / CSE.
(c) A good answer would point out that increasing leverage always increases expected earnings
growth. The payout increases leverage (in this case, it makes the leverage less negative).
(d) The per-share value of the shares will drop by the amount of the dividend per share.
[Note: if the payout were via a share repurchase, there would be no effect on per-share
value.]
(e) ROCE = RNOA + FLEV(RNOA − NBC) = RNOA + FLEV×SPREAD where FLEV =
financial leverage.
SPREAD = operating spread (= RNOA − NBC), where NBC = net borrowing costs (after
tax).
ROCE, a measure of bottom line profitability, is affected by operating profitability, financial
leverage and operating spread. Financial leverage levers the ROCE up or down through
financing activities. This means that the extent to which net operating assets (NOA) are
financed by common shareholders’ equity (CSE) or net financial obligations (NFO) affects
ROCE. In particular, ROCE (bottom-line performance) is levered up over the RNOA
(operating profitability) if the firm has financial leverage and the return from operations is
greater than the borrowing costs. In this case the firm earns more on its equity if NOA are
financed by NFO, provided that the spread is positive (i.e. profitability of operations higher
than net borrowing costs).

Question 2

The income statement and balance sheet amounts for a firm for 2012 – 2015 are
summarised below (in millions of dollars). The firm has a required return for
operations of 9% p.a.

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AC3143 Valuation and securities analysis

2012 2013 2014 2015

£’m £’m £’m £’m
Core operating sales 1,906 1,985 2,064 2,147
Core operating expenses 1,773 1,846 1,919 1,997
Core operating income 133 139 145 150
Unusual operating income — — (45) 60
133 139 100 210
Net financial expense 7 8 8 9
Comprehensive income 126 131 92 201

Net operating assets 945 983 1,022 1,063

Net financial obligations 150 155 175 120
Common equity 795 828 847 943

Required:

(a) Calculate the following for 2013–2015:

 Return on net operating assets (RNOA)
 Core return on net operating assets (Core RNOA)
 Free cash flow
 Net payments to common shareholders
 Net payments to net debt holders
 Asset turnover
 Core profit margin
 Growth rate for net operating assets
Use beginning-of-period balance sheet numbers in denominators.
[10 marks]
(b) On the basis of these financial statements, forecast
i. Abnormal operating income for 2016 and 2017.
[2 marks]
ii. Abnormal operating income growth for 2017.
[2 marks]
(c) Value the equity at the end of 2015 using two methods:
i. Abnormal operating income valuation
[2 marks]
ii. Abnormal operating income growth valuation
[2 marks]
(d) Calculate the enterprise price-to-book ratio implied by your valuation in (c).
Also, calculate the enterprise trailing and forward P/E ratios implied by your
valuation.
[4 marks]
(e) After making your valuation you discover that the firm has 37 million employee
stock options outstanding, valued at £10 per option. The firm’s tax rate is 35%.
How does this information change your calculation of the enterprise
price-to-book ratio?
[3 marks]

Reading for this question

This question tests candidates’ understanding of abnormal earnings and the clean surplus
accounting concept. A discussion of abnormal earnings can be found in Chapter 7 of the subject
guide, Chapter 7 of Healy and Palepu and also Chapter 5 of Penman.

18
 Examiners’ commentaries 2015

Approaching the question

(a) RNOA: Comprehensive income / Net operating assets.

Core RNOA: Based on core operating income.
Free cash flow: OI − ∆ NOA = FCF.
Net payments to common shareholders = CI − ∆CSE = Net dividend (d).
Net payments to net debt holders = F = FCF − d.
ATO: Core operating sales / Net operating assets.
Core PM: Core operating income / Core operating sales.
g(NOA): (NOAt − NOAt−1 )/NOAt−1 .
(b) With constant core RNOA, ReOI2016 = (0.147 − 0.09) × 1,063 = 60.591.
With NOA growing at 4.0%, NOA2016 = 1.04 × 1,063 = 1,105.52.
ReOI2017 = (0.147 − 0.09) × 1,105.52 = 63.015.
(This is also ReOI2016 × 1.04).
Abnormal operating income growth for 2017.
Abnormal OI Growth (AoIG) = ∆ReOI2017 = 2.424.
(c) Value the equity using two methods:
i. Residual operating income valuation.
As RNOA is constant, ReOI will grow at the NOA growth rate:
60.59
VN OA = 1,063 + = 2,274.8.
1.09 − 1.04
NFO = 120.0.
VE = 2,154.8.
ii. Abnormal operating income growth valuation.
As ReOI grows at 4%, so will AOIG.
OI2016 = 1,063 × 0.147 = 156.26.
 
N OA 1 2.424
V = 156.26 + = 2,274.8.
0.09 1.09 − 1.04
NFO = 120.0.
VE = 2,154.8.
(d) Calculate the enterprise price-to-book ratio implied by your valuation. Also, calculate the
enterprise trailing and forward P/E ratios implied by your valuation.
2,274.8
Enterprise P/B = = 2.14.
1,063
2,274.8
Forward enterprise P/E = = 14.56.
156.26
2,274.8 + 169 VN OA + FCF
Trailing enterprise P/E = = 11.64 = .
210 OI2015
(e) After making your valuation you discover (in footnotes) that the firm has 37 million
employee stock options outstanding, valued at £10 per option. The firm’s tax rate is 35%.
How does this information modify your calculation of the enterprise price-to-book ratio?
VN OA before options: 2,274.8.
Option value: £10 × 37 mil = 370.0.
Tax benefit (at 35%): 129.5 240.5
N OA
V 2, 034.3
Enterprise P/B = 2,034.3/1,063 = 1.91.

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AC3143 Valuation and securities analysis

Question 3

The following is an extract from Melodia plc’s reformulated income statement

(values in millions of pounds):

2014
£’m
Net sales 14,108
Other operating expenses 4,772
Depreciation 2,628
Net financial expense 600

The reformulated balance sheet of Melodia plc is as follows (values in millions of

pounds):

2013 2014
Intangible assets 13,500 16,250
Property, plant and equipment 9,000 13,500
Inventory 6,150 9,226
Operating obligations 8,850 13,276
Interest-bearing debt 6,900 10,350
Called up share capital 4,500 6,750
Share premium 4,620 5,600
Retained earnings 3,780 3,000

Required:

(a) Calculate the free cash flow (FCF) of Melodia plc for the year 2014.
[6 marks]
(b) For the year 2014, Melodia’s cost of equity is 8%, cost of debt is 6% and the tax
rate is 10%. Calculate its weighted average cost of capital (WACC) for this
year. Assume that the market values of debt and equity are equal to their book
values.
[4 marks]
(c) Under the competitive equilibrium assumption the terminal value in the
discounted cash flow model is the present value of the end-of-year book value of
equity in the terminal year. Explain.
[5 marks]
(d) Discuss the limitations of the Present Value of Discounted Free Cash Flow
(PVDCF) method.
[5 marks]
(e) Explain why terminal values in accounting-based valuation are significantly less
than those for DCF valuation.
[5 marks]

Reading for this question

For (a), this question requires calculation of Free Cash Flow. The calculation of free cash flow is
covered under securities analysis section of the subject guide. It is also explained in Chapter 4
(Cash Accounting, Accrual Accounting and Discounted Cash Flow Valuation) of Penman
textbook and Chapters 7 (Prospective Analysis: Valuation Theory and Concepts) and 8
(Prospective Analysis: Value Implementation) of Healy and Palepu textbook.

For (b), this question requires candidates’ understanding of weighted average cost of capital. A
discussion of the cost of capital and the formula for its calculation can be found in Chapter 8
(Securities Valuation) of the subject guide.

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 Examiners’ commentaries 2015

For (c) and (e), Penman, Chapter 5 (Accrual Accounting and Valuation: Pricing Book Values)
provides a discussion of terminal (also known as continuing) value assumptions and calculations.

For (d), Chapter 8 of the subject guide (Securities Valuation).

Approaching the question

(a) Based on the given information above, the calculation of FCF as the difference between
operating income and net operating assets is quite straightforward. Operating income is
calculated from the information given in the income statement of Melodia plc and the
changes in net operating assets are calculated based on the values of the operating assets in
years 2011 and 2012. These are taken from the balance sheet of Melodia plc.
FCF = Operating Income − Change in net operating assets.
Operating Income = 14,108 − 4,772 − 2,628 = 6,708.
Net operating assets (2014) = 16,250 + 13,500 + 9,226 − 13,276 = 25,700.
Net operating assets (2013) = 19,800.
Change in net operating assets = 5,900.
FCF = 6,708 − 5,900 = 808.
(b) The cost of equity can be derived from the WACC formula, which requires knowledge of the
market values of debt and equity. Since these are not available, the stated assumption that
market values of debt and equity are equal to their book values implies that the book values
of debt and equity should be used in the formula. Candidates should bear in mind that only
interest-bearing debt is relevant for the calculation of WACC. Therefore, the operating
obligations are not relevant for the calculation of WACC. After working out the proportions
of debt and equity (based on their book values), the cost of equity can be inferred as the
only unknown variable in the WACC formula.
WACC = V E /(V E + V D ) × rE + V D /(V E + V D ) × rD × (1 − τ ).
WACC = 0.33 × 8% + 0.67 × 6% × (1 − 0.1) = 6.25%.
(c) In calculating terminal values, investors usually have to make an assumption about the
growth and competitive advantage of the company after the period of the last explicit
forecast until infinity (or until the firm exists). These assumptions are usually that the
company will grow at a constant rate or that the company will generate the same level of
cash flows for ever. In answering this question candidates should think about the
implications of each of the two scenarios. Growing at a constant rate implies that the
company will continue to identify investment opportunities that generate abnormal profits.
Growing at zero rate implies that competition will limit the ability of the company to
generate abnormal profits.
(d) An excellent answer to this question will discuss the limitations of the PVDCF method
along the following lines: Is FCF, on which the PVDCF model is based, a good indicator of
profitability and why? Is FCF a good indicator of PE and PB ratios and why? Does
PVFCF work in all cases? Is PVFCF used by professional analysts?
(e) DCF terminal values include the present value of all expected cash flows beyond the forecast
horizon. Note that the expected cash flows beyond the forecast horizon can be broken down
into two parts: normal and abnormal. Since the terminal value in the accounting-based
technique includes only the abnormal earnings (expected earnings minus cost of capital
times beginning book value of equity), the terminal values in accounting-based valuation are
significantly less than those for DCF valuation. The accounting-based approach recognizes
that current book value and earnings within the forecast horizon already reflect many of the
cash flows expected to arrive after the forecast horizon.

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AC3143 Valuation and securities analysis

Question 4

Answer all parts of this question:

(a) Nova Medica Ltd announces £12 million rise in profits. Is its stock price going
to rise? Explain.
[10 marks]
(b) Assume Cure Ltd is an identical company to Nova Medica Ltd. The only
difference between the two companies is that Cure Ltd capitalises its R&D
investments whereas Nova Medica Ltd expenses them. In the same period when
Nova Medica Ltd announces £12 million increase in earnings, Cure Ltd
announces £18 million increase in earnings. How will the price of Cure Ltd
change relative to the price of Nova Medica Ltd?
[8 marks]
(c) Critically assess how accounting analysis may improve accounting-based
valuations.
[7 marks]

Reading for this question

For (a), candidates need to understand the link between accounting information (i.e. earnings)
and stock prices. They need to refer to the empirical evidence on this issue (e.g. Ball and Brown
1968), which can be found in Chapter 9 of the subject guide.

Parts (b) and (c) require candidates to make a link between two different topics covered in the
syllabus: accounting analysis, covered in Chapter 3 of Palepu, Healy and Bernard and Chapter 2
of Penman, and empirical evidence on the link between accounting information and stock prices,
covered in Chapter 9 of the subject guide.

Approaching the question

(a) Candidates should first discuss the usefulness of accounting information to capital markets
as documented by Ball and Brown (1968). They should refer to the magnitude of the
association between accounting information and market prices and its dependence on the
level of investors’ expectations before the earnings announcement. Since the question does
not give any information about investors’ expectations for the profits of New Pharma Ltd,
candidates need to condition their answer on the level of market/investor expectations.
An excellent answer to this question will also refer to the empirical literature on the
magnitude of the earnings response coefficient (e.g. Easton and Zmijewski, 1989; Kormendi
and Lipe, 1987; Ali and Zarowin, 1992).
(b) When answering this question it is important to first understand the factors that cause
changes in a firm’s stock price. Since the stock price is derived from the discounted value of
future cash flows (from the DCF model) anything that changes the expected future cash
flows will have an effect of the stock price. Therefore, candidates should first try to answer
the question whether a change in accounting policy with no underlying change in economic
reality will affect the future expected cash flows of a firm.
(c) The obvious answer to this question is yes although there are many ways to justify it. One
may argue that accounting analysis may enable an analyst to get better estimates of future
residual earnings through better estimates of persistence in residual earnings. A very good
answer will include examples. An excellent answer will quote Lev and Thiagarajan (1993) or
Sloan (1996).

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 Examiners’ commentaries 2015

Question 5

The summarised balance sheets of Marlene Ltd are as follows (values in millions of
pounds):

2013 2014
£’m £’m
Net operating assets 105,000 123,000
Financial assets 20,100 22,200
Financial obligations 56,100 63,900
Common shareholders’ equity 69,000 81,300

In 2014 operating income is £16,800 (million) and the forecast growth rate of net
operating assets 3%.

Required:

(a) Assuming that the weighted average cost of capital for the firm (WACC) =
9.5%, use Forecasting from Book Values (SF1 Forecasting), Forecasting from
Earnings and Book Values (SF2 Forecasting) and Forecasting from Accounting
Rates of Return (SF3 Forecasting) to estimate the value of Net Operating
Assets (NOA) in the year 2014. Critically discuss your results.
[5 marks]
(b) Explain under which conditions the 3 methods in (a) would be applicable for
estimating NOA.
[8 marks]
(c) How does simple forecasting differ from full forecasting?
[4 marks]
(d) What is the difference between SF1 and SF2 forecasts? What is the difference
between SF2 and SF3 forecasts?
[8 marks]

Reading for this question

This question tests candidates’ understanding of simple forecasting methods. The background
reading for this question can be found in Chapter 7 of the subject guide (Prospective
Performance Evaluation and Valuation) and Chapters 14 (Anchoring the Financial Statements:
Simple Forecasting and Simple Valuation) and 15 (Full Information Forecasting: Valuation and
Business Strategy Analysis) in Penman.

Approaching the question

(a) This question should be approached by first calculating the value of net operating assets
under each of the three simple forecasting methods:
SF1: Value of NOA = Value of the firm = NOA2012 .
SF2: Value of NOA = Value of the firm = NOA2012 + (OI2012 − rf × NOA2011 )/rf .
SF3: Value of NOA = Value of the firm = RNOA2012 × (RNOA2012 − g)/(rf − g) where:
RNOA2012 = OI2012 /NOA2011 .
(b) A good answer would continue with a discussion of what types of activities and firms each of
these methods is appropriate for. An excellent answer would include a discussion of how
SF1, SF2 and SF3 values compare to each other.
(c) A good answer would mention that simple forecasts are quick approximations, but they
serve as a starting point to full information forecasts. They ensure simplicity at the expense
of accuracy. An excellent answer would then go on to describe what simple and full forecasts
are based upon. More particularly, simple forecasting is based on historical (current and

23
AC3143 Valuation and securities analysis

past) financial statements. Simple forecasts embed all the concepts needed for forecasting,
but they use fewer factors to make the forecasts, and also take into account no information
outside the financial statements (e.g. macroeconomic conditions, industry, etc.). Full
information forecasting instead takes into account the full set of factors that drives business
profitability and growth, and is based both on information from the financial statements and
on information outside the financial statements.
(d) One way to approach this question is to discuss first the assumptions embedded in each type
of simple forecasting. More particularly, what is the assumption about abnormal earnings
growth under SF1, SF2 and SF3 forecasts? What part of financial statements is each of the
simple forecasts based on? Excellent answers would make references to formulas, industry or
company examples.

Question 6

Answer all parts of this question:

(a) What are the critical drivers of industry profitability?

[10 marks]
(b) Fred argues: “The standards that I like most are the ones that eliminate all
management discretion in reporting – that way I get uniform numbers across all
companies and dont have to worry about doing accounting analysis.” Do you
agree? Why or why not?
[7 marks]
(c) Which of the following types of firms do you expect to have particularly high or
low asset turnover? Explain why.
a. Supermarket
b. Pharmaceutical company
c. Jewellery retailer
d. Software company
[8 marks]

Reading for this question

For (a), Chapter 2 of Healy and Palepu.

For (b), Chapter 3 and Chapter 4 of Healy and Palepu.

For (c), the reading for this question can be found in Chapter 5 of Healy and Palepu and
Chapter 4 of the subject guide.

Approaching the question

(a) • How does rivalry among existing firms affect profitability and what factors influence
existing firm rivalry?
• How does threat of new entrants affect industry profits and what factors mitigate the
threat of new entry?
• How does the threat of substitute products affect industry profitability an what does the
importance of substitutes depend on?
• How is the bargaining power of buyers linked to industry profitability and what is the
bargaining power of buyers determined by?
• How does the bargaining power of suppliers affect industry profitability? What factors
make suppliers’ bargaining ability to increase / decrease?

24
 Examiners’ commentaries 2015

(b) This question tests candidates’ understanding of accrual accounting. Factors that can be
discussed in a good answer include:
• What is accrual accounting?
• Does managerial discretion in financial reporting always lead to misreporting?
• What would happen if all discretion in accounting is eliminated?
An excellent answer to this question will provide arguments both for and against the
existence of managerial discretion in accounting and in the end will provide a view,
supported with relevant arguments, of why they would agree or disagree with the statement.
(c) The level of asset turnover should be linked to the type of product (e.g. necessity versus
luxury goods), type of firm strategy (cost versus differentiation advantage), cost basis, etc.

Section B

Answer one question and no more than two further questions from this section.

Question 7

Answer both parts of this question:

(a) How can one exploit mispricing in the capital markets in the context of IPOs?
[12 marks]
(b) How do glamour stocks differ from value stocks?
[13 marks]

Reading for this question

Chapter 11 of the subject guide.

Approaching the question

(a) Discuss relevant evidence by Teoh, Welch and Wong (1998) on opportunistic earnings
management via high accruals in the year prior to the IPO.
(b) Discuss relevant evidence by Lakonishok, Schleifer and Vishny (1994) and DeBondt and
Thaler (1985).

Question 8

Answer both parts of this question:

(a) What are the characteristics of Internet stocks that influence their valuation?
Explain.
[10 marks]
(b) Is there any difference in the relative importance of financial and non-financial
information before and after the dot.com bubble? Explain.
[15 marks]

Reading for this question

This question addresses the application of valuation analysis with regard to Internet stocks. This
is discussed in Chapter 10 of the subject guide.

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AC3143 Valuation and securities analysis

Approaching the question

(a) Describe the nature of the Internet firms and why it may be difficult to value them.

(b) This question should be approached by first discussing the empirical evidence by Trueman,
Wong and Zhang (2000) on the relative importance of financial and non-financial
information in the pre-Internet peak period. It should be followed by a discussion of the
empirical evidence by Keating, Lys and Magee (2003) for the post-peak period. An excellent
answer to this question will refer to the findings of Hand (2000 and 2001) and discuss how
these findings reconcile the different results documented for the pre- and post- Internet peak
periods.

Question 9

Answer all parts of this question:

(a) What are the main objectives of an accounting analysis?

[5 marks]

(b) How can fundamental analysts trade on the basis of an accounting analysis?

[10 marks]

(c) What evidence is there of abnormal returns to an accounting analysis?

[10 marks]

Reading for this question

The nature of accounting analysis in the context of trading strategies is discussed in Chapter 11
of the subject guide.

Approaching the question

(a) Most broadly, the objective of accounting analysis is to evaluate the degree to which a firm’s
accounting captures the underlying business reality. An excellent answer to this question
will give certain examples (e.g. difference between accounting picture and reality related to
intangible investments, etc.).

(b) One way to address this question is to refer to Lev and Thiagarajan (1993) and discuss their
trading strategy based on fundamentals, selected through accounting analysis. An excellent
answer will discuss the empirical findings, e.g. magnitude of returns documented; aggregate
fundamental score, explanatory power of earnings, etc.

(c) One way to address this question is to refer to Sloan (1996) and discuss their trading
strategy based on accruals. An excellent answer will discuss the empirical findings, e.g.
magnitude of returns documented.

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 Examiners’ commentaries 2015

Question 10

Answer all parts of this question:

(a) How does knowledge of the main determinants of price-to-book (PB) ratios in
efficient markets help you to explain the following evidence, reported from
Penman’s large sample study?
Abnormal earnings in post-horizon years
Year relative to current year (Year 0)
PB ratio level PB ratio 0 1 2 3 4 5
High 6.7 0.18 0.23 0.22 0.22 0.23 0.24
Medium 1.4 0.03 0.03 0.03 0.04 0.05 0.03
Low 0.4 −0.09 −0.07 −0.07 −0.04 −0.02 −0.04
[10 marks]
(b) How do contrarian strategists interpret high and low PB and price-to-earnings
(PE) ratios?
[7 marks]
(c) Why are price-to-earnings (PE) ratios more volatile than price-to-book (PB)
ratios?
[8 marks]

Reading for this question

Parts (a) and (c) require understanding of the implications of price-to-earnings and price-to-book
ratios. These are discussed in detail in Chapter 8 of the subject guide and Chapter 7 of Palepu,
Bernard and Healy. For (b), Chapter 8 p.143 of the subject guide.

Approaching the question

(a) In efficient markets, the firm’s PE ratio depends on the firm’s:

• expected growth in abnormal earnings
• current earnings
• cost of equity capital.
A discussion of the direction of this dependence will constitute an excellent answer to the
above question.
In efficient markets, a firm’s PB ratio depends on the firm’s:
• expected level of abnormal earnings
• current book value of equity
• cost of equity capital
(b) Given the above discussion of the determinants of the PB ratio, controlling for risk (and
hence the cost of equity capital), the higher the stock’s PB ratio, the higher the stock’s
subsequent abnormal earnings deflated by the current book value of equity. Penman checks
whether PB ratios do forecast subsequent abnormal earnings.
What does the provided table reveal about the correlation between PB ratios and
subsequent performance? Does this evidence validate or reject the above theory?
(c) In efficient markets, a firm’s PE ratio depends on the firm’s:
• expected growth in abnormal earnings
• current earnings
• cost of equity capital.
PE ratio = PB ratio × Book value of equity/Earnings = PB ratio/ROE.
Following from the above, what factors explain a firm’s PE ratio? What is the key difference
in the factors that explain the two ratios?

27