FTX3044F Tutorial 4

Due: Week beginning 16 March 2015

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Question 1
ABC Ltd is currently trading at a price of R28 per share. You forecast that the share will
trade at a price of R30 by year-end and that a dividend of R2 will be paid during that
period.
Your analysis of the market indicates that the market risk premium is 8% and the risk-free
rate is 5%. ABCs beta relative to the market is 1.3.
REQUIRED:
Assuming you already manage a well-diversified portfolio of shares, would you add ABC to
your portfolio? Why or why not?
(6
marks)
Forecast return on the share is:
= [(30-28)+2]/28 = 14.3%

[2 marks]

The expected return based on the CAPM is:

= 5 + 1.3 (8) = 15.4%

[2 marks]

The share is therefore overpriced as it has a negative alpha (-1.1%). We would therefore
not add it to our portfolio but we should short sell the share and invest the proceeds in our
portfolio to take advantage of its mispricing.
[2 marks]
Question 2
Please refer to the documents named after each company on Vula. For the international
examples of Enron and Allied Capital + the South African examples of CS Holdings,
Leisurenet and Regal Bank explain the following per company:
a) Briefly explain the business of the company and the crisis that engulfed it?
(2
each)
b) What was the role of accounting in each crisis?
(2
each)

marks
marks

c) Classify the type of accounting shenanigan according to the table in the lecture
slides
(1 mark each)
TOTAL 6 + (5x5) = 31
Enron:

a) Enron was primarily an energy company engaged in the production and trade of
energy. When accounting shenanigans came into the light the bankruptcy of the
Enron resulted.
b) Accounting was central to the crisis. Enron was able to stay in business for years
whilst hiding liabilities and overstating income.
c) Revenue of questionable quality and hidden liabilities.
Allied Capital:
a) Allied capital was a private equity investment firm that fought a long fight with David
Einhorn regarding its valuation of low liquidity investments. This eventually resulted
in a share price crash and a takeover of the firm.
b) Fair valued assets were overvalued and the company was thus not as profitable as
it appeared.
c) Revenue of questionable quality.
CS Holding:
a) CS Holding was a South African provider of training services. A once off transaction
around yearend was used to lift profits and when it came to light led to the eventual
sale of the company to Bytes.
b) A negative profit was made positive by the posting of a once off profit around
yearend that was reversed in the following year.
c) Boosting income with one-time gains.
Leisurenet:
a) Leasurenet was the forerunner of Virgin active in South Africa. It operated gyms.
Eventually it ran out of cash that showed its aggressive revenue recognition.
b) Revenue linked to long term membership was recognised immediately even though
the accompanying cost of that membership was not recognised. This led to an
overstatement of earnings relative to cash.
c) Revenue of questionable quality.
Regal Bank:
a) A private bank with aggressive revenue recognition policies and share price
manipulation schemes that eventually resulted in a run on deposits and its closure.
b) Aggressive earnings recognition.