Time allowed: 2 hours
Total number of questions: Five
Instructions to candidates: Answer any 3 questions.
Each question is worth 20 marks. The total
(out of 60) will be converted to a percentage
after marking
Equipment permitted: Non-programmable calculators are permitted.

Question 1
PART A (You need to answer both parts a and b)
The following information is derived from the latest financial statements of FSH Co and LLM Co.
Both Companies are listed on a stock exchange and engaged in construction business (all amounts
are in thousands of pounds).
Sales Earnings Book value
of Equity
Market value
FSH Co £90,000 £7,000 £35,000 £115,000
LLM Co £78,000 £5,600 £27,000 £95,000
Light Co is also engaged in construction. It is privately owned and reported the following numbers
for the latest period (all amounts are in thousands of pounds.)
Sales Earnings Book value Market value
Light Co £40,000 £4,200 £18,000 ?
The managing Director of Light Co is considering an initial public offer of the shares and would like
to have an indication of the value of the company’s common shares.
There is no debt in any of the companies
Required:
(a) Compute three relevant price comparable ratios for FSH Co and LLM Co.
(3 marks)
(b) Apply the three ratios computed in (a) above to the relevant numbers for Light Co and
put forward an indicative estimate of the total market value of Light Co. State any
assumptions.
(6 marks)
(c) Critically evaluate the advantages and limitations of the use of price comparable ratios
in arriving at a valuation of common shares and state which, in your opinion, is the
most relevant ratio in valuing Light Co.
(6 marks)
PART B
Your brother started a software firm as a sole trader. During its first three years, the firm reported
annual losses. An interested buyer has approached him, and the investment bankers representing
the buyer want to value his firm using multiples. Because the firm has reported losses, they suggest
basing the valuation on book value per share and using SAP and Symantec as comparables, which
provide a book value multiple of 6. Your brother has come to you for advice and you believe their
methodology is flawed, and their offering price is too low.
(NB: SAP and Symantec are one of the biggest software companies in the world.)
Required:
What arguments can you make in support of your position? Suggest other appropriate
valuation methods.
(5 marks)
(Total 20 marks)

Question 2
PART A (You need to answer both parts a and b)
Below are summary numbers from reformulated balance sheets for 2017 and 2018 for Radik
Company, along with numbers from the reformulated income statement for 2018 (in thousands of
pounds).
31 June 2018 31 June 2017
Operating assets 4,586 4,350
Operating liabilities 1,589 1,572
Financial assets 94 77
Financial liabilities 1,720 1,970
Operating income (after tax) 658
Net financial expense (after tax) 37
The company paid a dividend during 2018.
There were no issues or repurchases of shares.
Required:
(a) The Managing Director of Radik Company strongly believes that free cash flow creates
value for the shareholders and he is therefore keen on ensuring that the company
maintains a positive free cash flow. Explain to him why free cash flow can be regarded
as a dividend (that is distribution of value) rather than the value created.
(3 marks)
(b) Compute the dividend paid during 2018.
(4 marks)
(c) Calculate the company’s free cash flow by reference to operating income, operating
assets and operating liabilities. Show your workings.
(4 marks)
(d) Demonstrate that the free cash flow derived in (a) above can also be computed by
reference to financial expense, financial assets and financial liabilities. Show your
workings.
(4 marks)
Part B
In its third quarter earnings statement in October 2018, Netflix (An American media service provider
listed on NASDAQ) reported negative free cash flow of $859 million, the biggest figure in its history.
The company’s shares jumped 4.7% the next day after the announcement.
Required:
Discuss possible reasons why investors rewarded rather than punished Netflix.
(5 marks)
(Total 20 marks)

Question 3
Rainbow plc prepares financial statements to 31 March each year. At 31 March 2018 the book value
of common equity was $500 million.
There were 150 million common shares outstanding at the end of 2018. There is no debt.
An analyst forecasted the company’s earnings and dividends for 2019, 2020 and 2021 as follows (all
amounts are in millions of dollars):
2019 2020 2021
Earnings 198.4 234.0 366.2
Dividends 33.0 50.0 70.4
Book value ? ? ?
Residual earnings ? ? ?
The required rate of return on equity is 11%. After 2021, the residual earnings are expected to grow
at the rate of 6%.
6
Required:
(a) It is said that current financial statement are of
poor quality if they mislead the analyst in forecasting future earnings. Discuss any three
of the five questions an analyst should ask when analysing the quality of financial
statements.
(3 marks)
(b) Forecast the book value of the company and
the residual earnings for 2019, 2020 and 2021.
(6 marks)
(c) Estimate the value of each share in Rainbow
plc based on the forecast residual earnings.
(6 marks)
(d) Critically evaluate the ‘residual earnings’
method of valuation, identifying the circumstances in which it is an appropriate method
to use.
(5 marks)
(Total 20 marks)

Question 4
Valour Co reports the following income statement for the year ended 30 June 2018:
2018
£000
Turnover 4,800
Cost of sales (3,850)
Gross profit 950
Administrative expenses (190)
Restructuring charges (15)
Gain on the sale of a non-current asset 47
Operating profit 792
Interest expense (142)
Earnings before tax 650
Taxation at 20% (130)
Earnings after tax 520

Discontinued operations, net of tax (12)
Net income 508
Valour Co had 1,200,000 ordinary shares in issue during 2018. When Valour Co announced its
results for 2018, it stated that its ‘normalised’ earnings per share had increased even though its
‘statutory’ earnings per share had fallen.
Required:
(a) Compute the operating margin ratio based on the reported income statement. You should
use the operating profit AFTER tax.
(3 marks)
(b) Restate the income statement so that transitory (non-recurring) items are excluded and
re-compute the operating profit margin.
(4 marks)
(c) Discuss which of the operating margins computed in (a) and (b) above provides the best
indicator of future operating margins.
(2 marks)
(d) Compute earnings per share on the basis of the reported results and the normalised
earnings per share
(5 marks)

(e) Discuss some features in the financial statements that you would look for to identify a
firm as a growth company? (6 marks)
(Total 20 marks)