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QUALIFYING EXAM
OCTOBER 2014
Corporate Financial Management (BE-2)
GENERAL
The following are general points that need to be noted by prospective candidates. Some of
these were noted in the previous sitting.
QUESTION 1
Some candidates did not understand the difference between an annuity and a retirement
annuity. A retirement annuity is what is purchased during ones working life. This requires
the payment of regular premiums to a fund until a certain age is reached. An annuity, on the
other hand, is a series of payments at regular intervals. In this question candidates were told
that a CEO reached the age of 65 and purchased an annuity with payments to her as
indicated in the question. The question asks how much the NPV is that is needed by the
insurance company to service the annuity. There are no risks to the insurance company if
the CEO is ill, retires early, fails to pay premiums or any other factors relating to the CEO.
The insurance company simply has to pay out the payments as are noted in the table. There
is no concern as to whether the CEO will be able to pay in the future. She is being paid by
the insurance company.
1.1
The question requires the analysis of three annuities. The present value is the sum of
all the present values of each individual payment. So, either the present value for
each individual payment must be determined using the present value table or an
entire annuity must be determined using the present value of an annuity table. A
number of candidates took each of the individual payments and used the annuity
present value table not the R1 present value table. This is incorrect and resulted in
an amount that is far too high. Future candidates are advised to look at the
memorandum or the prescribed reading when preparing for a question such as this.
Those candidates who understood this gained some easy marks.
1.2 and 1.3
These questions required thinking about the question and applying the
knowledge from the prescribed reading or from their life experience. In certain cases,
the two questions 1.2 and 1.3 were marked as a single question.
QUESTION 2
2.1 and 2.2
The Internal rate of return (IRR) is a frequently used concept. It is rather
difficult to calculate and so a process has been suggested in the prescribed reading
to guess two interest rates and use a formula to find the required IRR by
interpolation. The arithmetic was well performed by many candidates. The formula in
the examination paper contained an error. Candidates using it as found were not
penalised. Any candidate noting the error and using the correct formula was awarded
a bonus mark. The memorandum is correct.
2.3
Required candidates to demonstrate that they knew the strengths and short-comings
of the IRR. As indicated above the method for calculating IRR suggested in the
solution is by considering a low and high discount rate. This is neither a merit nor a
criticism of IRR. It is merely a method of finding it. The fact that it cannot be found
simply using an equation makes it difficult to calculate. This difficulty can be regarded
as a criticism of IRR.
QUESTION 3
3.1 to 3.4
The question required candidates to demonstrate the advantages of
diversifying a portfolio. The risk (as represented by the standard deviation) of an
investment in bonds was compared with an investment in shares under three
different scenarios. Candidates were then asked to explain the concepts of how risk
was reduced by diversification.
To find the return on the portfolio, a number of candidates added the return for the
bonds to that for the shares instead of using the average. This is incorrect and led to
too high a value for the return for the portfolio and misleading results.
Candidates should also note that the standard deviation of a combined portfolio is not
the weighted average of the components of the portfolio. The standard deviation
needs to be calculated. It is the fact that the (risk) standard deviation of the portfolio
is less than the average of the components that is one of the reasons making
diversification a benefit.
3.5
Many candidates failed to mention that the correlation between the return on the
bonds and the shares was negative.
QUESTION 4
This is a takeover situation where the value of shares in a two companies needed to be
considered to determine the equivalent ratio of the shares of each company. Such takeovers
usually offer a benefit to shareholders of the companies. In 4.1, there is no benefit and a
balance of the market values of the two companies needed to be found. In 4.2, the benefit
(synergistic benefit) was then considered and the situations where this benefit accrued to
Target and Capture companies required analysis.
QUESTION 5
5.1
5.2
5.3
A situation is described with two scenarios one with a 75% chance of occurring and a
possibility of strikes. This means that there is a 25% chance of strikes. Many
candidates failed to take the possibility of strikes into account thus giving too high an
expected return for the mining shares.
The factors for each type of share is given. A number of candidates added these
factors together to get a for the portfolio. A little thought will show that this is
erroneous thinking as it will lead to a very high value for .
The advice given to a client as to what to do in the case of a recession required
thought and a number of candidates suggested a high risk portfolio as a solution.
This is clearly wrong.
QUESTION 6
6.1
6.2
6.3
The question asked candidates to discuss the Altman model. Few candidates
discussed any limitations to the model.
This question considered a government bond with an annual coupon of 7.5%. The
interest was invested as it became due at the then current interest rate. On maturity,
all the sums were available to the investor. The compound interest yield was
required. This question needed candidates to use the future value table. The
question was poorly answered.
This question on the working capital cycle was well understood and well answered.
END OF REPORT