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FinancePRACTICE QUESTIONS FOR CFS & CPA

january 2016


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Practice Questions Finance

1 Meeting financial objectives generates more profits but not without non-financial objectives.Therefore, it is essential to identify each type of objectives separately for planning purpose.

Which of the following can be identified as a non-financial objective of an organisation?a Achieve and maintain a AA bond ratingb Conformance with IS0 9000c Maintain a positive cash flowd Maintain earnings per share 15% annually

2 Hat plc is undertaking a project that worth $10m. The management of Hat plc wishes to raise thesum by issuing rights share at a discount of 20%. Hat plc has in issue 50m $1 ordinary shares. Thecurrent market value is $100m.

What is the amount of new shares needed for rights issue? (to the nearest whole number)a 4,170,000b 5,000,000

c 6,250,000d 25,000,000

3 The opinion of an investor regarding efficient market hypothesis is:

“In a market which is strong -form efficient, it can be expected that any existence of ‘creativeaccounting’ or ‘window -dressing’ of financial accounts will adversely affect the market”.

State whether his opinion is correct.a The investor is having wrong opinion.b The investor is having a slight misunderstanding as he is addressing ‘creative accounting’ and

‘window-dressing’ as synonymous.c The investor is having a correct opinion.d The investor is wrong because ‘creative accounting’ or ‘window -dressing’ of financial accounts is

relevant in efficient market hypothesis.

4 Consider the following opinion that address efficient market hypothesis:

1. Markets which are semi-strong form efficient will not react to or be affected by window dressingor creative accounting.2. Share prices in markets which are weak-form efficient follow a random pattern of movement andit is not possible to predict future movements by studying past patterns.

Which of the following is a correct combination?a Statement 1 = True; Statement 2 = Trueb Statement 1 = True; Statement 2 = Falsec Statement 1 = False; Statement 2 = Trued Statement 1 = False; Statement 2 = False


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5 Declaration and issuance of bonus share will have influence on numbers of factors of a listedcompany.

Which one of the following will NOT be directly affected by a bonus issue?a Earnings per shareb Financial gearingc Issued share capitald Outstanding share capital

6 Consider the following statements:

1. EPS shows the amount of profit attributable to each ordinary share. But, it does not representactual income of the ordinary shareholders.2. Dividend per share is the ordinary dividend for the year to ordinary number of shares expressed interms of percentages (%).3. Dividend pay-out ratio is the percentage of earnings paid to shareholders as dividends. This shows

how well earnings support the dividend payments.4. Dividend cover represents how many times dividend could have paid from the profit attributableto creditors.

Which of the above (if any) is not appropriate?a 1 and 2 onlyb 2 onlyc 1 and 3 onlyd 2 and 4 only

7 When Wikii Co order for new supplies of inventory ‘W3s’, deliveries by supplier are sometimes madein 5 working days and sometimes take as long as 20 days. Daily consumption can be as low as 1 unitand as high as 6 units. The company maintains a buffer inventory of 40 units. The economic orderquantity for ‘W3s’ is 45 units.

What is the maximum number of units of this item that the Wikii could hold?a 120 unitsb 145 unitsc 160 unitsd 200 units

8 Harrods Ltd anticipates it would require an investment of $20,000 in current liability for theforthcoming year. It has targeted to maintain current ratio at 3:1, turnover to current assets at 5:1,

and acid test ratio at 4:2.

What would be the likely forecast sales turnover and inventory level of Harrods Ltd, based on itstargeted ratios?a Sales turnover = $120,000; Inventory = $60,000b Sales turnover = $300,000; Inventory = $20,000c Sales turnover = $120,000; Inventory = $40,000d Sales turnover = $300,000; Inventory = $60,000


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9 Which of the following situations indicates a company is over-capitalised?(i) Low sales revenue to working capital ratio(ii) High debt to equity ratio(iii) Sudden increase in quick ratioa (i) & (ii)b (ii) & (iii)c (i) & (iii)d (i) ,(ii) & (iii)

10 Which ONE of the following has the job of trying to ensure a successful issue for the company'sshares, by advising on an issue price for the shares, and trying to interest institutional investors inbuying some of the shares?a A sponsoring member firmb An issuing housec An underwriterd An intermediary

11 If Thm Ltd needs assurance that all if its issued shares are not bought by general public will besubscribed, it needs to pursue the services of:

a A sponsoring member firmb An issuing housec An underwriterd An intermediary

12 Bat has spent $2 million developing a new product and a further $800,000 on market research tofind out whether a market launch would be worth undertaking. The findings of the market researchwere as follows.

(a) To launch the product on the market, the company would have to spend a further $800,000 onequipment. This would be depreciated over three years by the straight-line method, and would havean estimated resale value of $200,000 at the end of this time.(b) The product would have a life of just three years, and profits after depreciation would be$500,000 in the first year, $600,000 in the second year and $300,000 in the third year.(c) There would be an initial investment of $120,000 in working capital in the first year and a further$140,000 of working capital would be needed in Year 2.(d) Instead of investing in the product launch, the company could sell the rights to the product toanother company for $500,000.

What are the estimated net cash flows from this project?a $560,000b $800,000c $900,000d $960,000


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13 Teai plc and Kophi plc are joint stock listed company. Teai plc and Kophi plc companies’ shares havebeen estimated with a beta value of 0.8 and 1.5 respectively. The expected market return is 12% .Teaiplc’ shareholders expect a return of minimum 10%. Kophi plc’s shareholders’ expected rate of returncan be calculated based CAPM method.

Which ONE of the following is the correct expected rate of return of Kophi plc’s shareholders?a 2%b 10%c 12%d 17%

14 ABC's shares have a beta value of 1.2. The market return is 10% and the risk-free rate of return is 6%.

What is the expected return on ABC's equity is?a 10%b 10.8%

c 14.8%d 15%

15 Company X and Company Y both pay an annual cash return to shareholders of 34.5 cents per shareand this is expected to continue in perpetuity. The risk-free rate of return is 8% and the currentaverage market rate of return is 12%. Company X's β coefficien t is 1.8 and Company Y's is 0.8.

What would be the predicted market value of each company's shares?a X = 220 cents; Y = 803centsb X = 308 cents; Y = 227 centsc X = 227 cents; Y = 308 centsd X = 803 cents; Y = 220 cents

16 A company is financed by a mixture of equity and debt capital, whose market values are in the ratio3:1. The debt capital, which is considered risk-free, yields 10% before tax. The average stock marketreturn on equity capital is 16%. The beta value of the company's equity capital is estimated as 0.95.The tax rate is 30%.

What would be an appropriate cost of capital to be used for investment appraisal of new projectswith the same systematic risk characteristics as the company's current investment portfolio?a 7.0%b 10%c 13.5%

d 15.7%


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17 A company issues $25 million of 5% convertible bonds at 102.00. The bonds are convertible in fiveyears' time into ordinary shares of the company, at the rate of 15 shares for each $100 of bonds. Thecurrent share price is $5.60.

What is the value of conversion?a $84b $100c $110d $120

18 CD has issued 50,000 units of convertible debentures, each with a nominal value of $100 and acoupon rate of interest of 10% payable yearly. Each $100 of convertible debentures may beconverted into 40 ordinary shares of CD in three years time. Any stock not converted will beredeemed at 110.

Estimate the likely current market price for $100 of the debentures, if investors in the debentures

now require a pre-tax return of only 8%, and the expected value of CD's ordinary shares on theconversion day is 2.50 per share.

a $111.11 per $100 of debenturesb $113.11 per $100 of debenturesc $115.11 per $100 of debenturesd $118.11 per $100 of debentures

19 5URL Co has only $60,000 to invest in the following divisible projects. None of the projects arerepeatable and can be delayed.

Year 0 Year 1 Year 2 Year 3 Year 4A (50,000) (20,000) 20,000 40,000 40,000B (28,000) (50,000) 40,000 40,000 20,000C (30,000) (30,000) 30,000 40,000 10,000

The cost of capital is 10%. Capital investment is made only in Year 0.

What is the approximate NPV from total investment (to the nearest whole number)?

Present value table (extracted)Year 1 0.909Year 2 0.826

Year 3 0.751Year 4 0.683

a $63,084b $56,800c $62,310d $44,230


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20 Tes plc, a UK company, expects to receive US$5m in 6 months’ time. In order to hedge thepossible exchange rate risk, which ONE of the following should Tes plc consider to undertake?a Sell US dollar futuresb Sell Euro futuresc Buy US dollar optionsd Buy Euro futures

21 SG Co has been offered with a project. The project will need an initial investment on a non-current asset of $100,000 and a further $5,000 on working capital. The estimated duration of theproject would be for 5 years. However, the project would need a further investment of $5,000 atthe end of year 4 as SG Co would need to replace one of its machinery. The cash flows from theproject would be as follows:

1 $10,0002 $20,0003 $30,000

4 $40,0005 $60,000

SG Co’s cost of capital is 10%.

Mr. Drake, finance manager of SG Co, as an initial appraisal of the project, calculate thediscounted payback period. What would be his likely result?

Present value table (extracted)1 0.9092 0.8263 0.7514 0.6835 0.621

a 4 years 8 monthsb 4 years 9 monthsc 4 years 10 monthsd 4 years 11 months

22 Compute NI Ltd’s cash cycle (assume period length is 360 days) based on the data providedbelow:

$’000

Sales 100Cost of sales 40Inventories 10Trade receivables 20Trade payables 5

a 25 daysb 63 daysc 117 daysd 119 days


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23 Little Inc. sells kids dress. The demand for this product is 40,000 units a year, at a steady rate. Thepurchase price of the product is $25 per unit. It costs $20 to place an order, and 40c to hold aunit for a year. Little Inc. uses economic order quantity as its ordering size.

What is the total annual cost of trading in this product? (assume 52 weeks a year)a $1,000,800b $1,008,400c $1,004,000d $1,000,400

24 A German company needs to pay US dollars to an American supplier in 90 days. How can ithedge the transaction using futures?a buy euro futures now, and close its position in 90 days by selling euro futures.b buy euro futures now, and close its position in 90 days by buy euro futures.c sell euro futures now, and close its position in 90 days by buying euro futures.d sell euro futures now, and close its position in 90 days by selling euro futures.

25 A UK company expects to receive 5 million US dollars in six months' time from a customer. Howcan it hedge this receipt on the US futures market? The current spot rate is £/$ 1.4310 and therelevant sterling futures contract is trading at £/$ 1.4275.

What is the number of contracts to be used to hedge the risk, if the spot rate in six months' timeis £/$1.4800 and the futures price is $1.4790.a 52 contractsb 54 contractsc 56 contractsd 58 contracts

26 A put option based on Max Co’s share has a premium of 80c and its strike (exercise) price is 520c.Sigma’s underlying share is currently quoted at 450c.

What does the premium consist of?a Only intrinsic valueb Only time valuec Both intrinsic value and time valued Neither intrinsic nor time value


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27 Why a company should needs to smooth out dividend payments?a Companies are likely to have a short-term target for a dividend pay-out ratio, and will try to

avoid volatility in dividends from one year to the next. Companies therefore generally smoothout dividend payments by adjusting only gradually to changes in earnings: large fluctuationsmight undermine investors' confidence.

b Companies are likely to have a long-term target for a dividend pay-out ratio, and will try toavoid volatility in dividends from one year to the next. Companies therefore generally smoothout dividend payments by adjusting only gradually to changes in earnings: large fluctuationsmight undermine investors' confidence.

c Companies are likely to have a long-term target for a dividend pay-out ratio, and will try toavoid volatility in dividends from one year to the next. Companies therefore generally smoothout dividend payments by adjusting only gradually to changes in earnings: smallerfluctuations might undermine investors' confidence.

d Companies are likely to have a long-term target for a dividend pay-out ratio, and will try toavoid volatility in dividends from one year to the next. Companies therefore generally smoothout dividend payments by adjusting only gradually to changes in earnings: large fluctuations

might boost investors' confidence.

28 Consider the following statements regarding ‘residual theory’: (i) If a company can identify projects with positive NPVs it should invest in them.(ii) Only when these investment opportunities are exhausted should dividends be paid.

Which of the above is NOT consistent with ‘residual theory’? a (i) onlyb (ii) onlyc (i) & (ii)d None

29 Consider the following statements regarding ‘scrip dividends’: (i) A scrip dividend is a dividend payment which takes the form of new shares instead of cash.(ii) A scrip dividend is a way of retaining profits within the business, and at the same time

paying a dividend.(iii) A scrip dividend converts profit reserves into issued share capital.

Which of the above is false?a (i) & (ii) b (i) & (iii) c (i), (ii) & (iii)d None


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30 A company issued some 6% bonds a few years ago. The bonds pay interest annually, and nowhave exactly five years remaining to maturity (the most recent interest payment just having beenmade). They will be redeemed at par. Investors in bonds of this type currently require a yield of7% per annum.

What will be the market value of these bonds?Year Discount factor at 7%1 0.9352 0.8733 0.8164 0.7635 0.713

a $91.36b $91.63c $95.19d $95.91

31 ESP Co has recently announced after-tax profits of $12 million and has a market capitalisation of$60 million. The company expects profits to increase by 25% for the forthcoming year. Thecompany is committed to increasing the dividend by 4% per annum for the foreseeable future.The company will maintain a constant dividend cover of 1·5 times throughout.

What is the predicted rate of return from the ordinary shares?a 4.1%b 11.5%c 17.3%d 20.7%

32 An investor holds some warrants that can be used to subscribe for ordinary shares on a one-for-one basis at an exercise price of $2.50 during a specified future period. The current share price is$2.25 and the warrants are quoted at 50c.

What is the warrant conversion premium?a $0.75b $2.00c $2.75d $3.00

33 A company has issued share warrants. Each warrant gives its holder the right to subscribe for onenew share in the company, in about three years time, at an exercise price of 780c. The warrants

are traded on the Stock Exchange and have a market value of 68c. The current market price ofthe shares is 762c.

What is the premium on the warrants?a 18cb 68cc 86cd 848c


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38 What categories of currency risk arise from the following:(i) When a company borrows in a foreign currency and make interest payments in that

currency, and repay the loan principal in that currency at maturity(ii) Whenever there is a foreign subsidiary in a group of companies.

a (i) = translation risk; (ii) = transaction riskb (i) = transaction risk; (ii) = translation riskc (i) = transaction risk; (ii) = economic riskd (i) = translation risk; (ii) = economic risk

39 Which of the following methods of managing different currency risk is appropriate?(i) Matching receipts and payments to reduce or eliminate its foreign exchange transaction

exposure(ii) Leading or lagging might be used to take advantage of foreign exchange rate

movements(iii) Matching assets and liabilities can be used to manage economic risk.

a (i) and (ii) only

b (i) and (iii) onlyc (ii) and (iii) onlyd (i), (ii) and (iii)

40 Mr. Orsi holds the following European-style options at expiry date.(i) A put option on 6,000 shares in Lock with an exercise price of 545c. The current market

price of the shares is 510c.(ii) A call option on 10,000 shares in Trim with an exercise price of 378c. The current market

price of the shares is 330c.(iii) A call option on 500,000 euros in exchange for the dollar, at an exchange rate of €1=

US$0.9000 when the current exchange rate is $0.9500.(iv) A put option on £250,000 in exchange for the dollar at a strike rate of £1 = US$1.4500,

when the current exchange rate is $1.4100.(v) A call option on a notional loan, giving you the right to borrow a quantity of funds for six

months at a strike rate (LIBOR) of 5%, when the current six-month LIBOR is 5.6%.

State in which case Mr. Orsi would exercise the option or allow the option to lapse?a (i) Exercise; (ii) Exercise; (iii) Exercise; (iv) Allow the option to lapse; (v) Exerciseb (i) Exercise; (ii) Allow the option to lapse; (iii) Exercise; (iv) Allow the option to lapse; (v)

Exercisec (i) Exercise; (ii) Allow the option to lapse; (iii) Exercise; (iv) Exercise; (v) Exercised (i) Allow the option to lapse; (ii) Exercise; (iii) Exercise; (iv) Allow the option to lapse; (v)

Exercise


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41 A US company has just provided a service to a UK company for £500,000. Settlement is due inthree months’ time and the US company wants to hedge the risk of a fall in the value of the UKsterling over the next three months. The following methods of hedging are being considered:

(i) Buy sterling call options now(ii) Buy sterling put options now(iii) Sell sterling futures now(iv) Buy sterling futures now

Which of the above would provide a hedge against exchange rate risk?a (i), (ii) and (iv)b (ii) and (iii)c (iii) and (iv)d (i) and (iv)

42 IPho Ltd has irredeemable 4% debt capital in issue with a nominal value of €20m. The currentmarket value of the debt capital is €10 million and the tax rate is 25%. The current market value

of equity shares of IPho Ltd is €30 million. The weighted average cost of capital has beendetermined as 10%.

The cost of equity of IPho Ltd would therefore be:a 11.3%b 11.8%c 12.3%d 12.8%

43 Which of the following is / are not an assumption(s) made when the weighted average cost ofcapital is used in investment appraisal?

(i) The project is small relative to the overall size of the company.(ii) The weighted average cost of capital reflects the company's long-term future capital

structure, and capital costs.(iii) The project has the same degree of business risk as the company has now.(iv) New investments must be financed by new sources of funds: retained earnings, new

share issues, new loans.(v) The cost of capital to be applied to project evaluation reflects the marginal cost of new

capital.a (i) and (v) onlyb (v) onlyc (iii) onlyd None


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44 In order to find the estimated market value of an equity share of Heav Co, the following data hasbeen provided by its finance manager:

Constant dividend payout ratio = 40%.Recent payment of dividend = €0.20 per equity share Return on all new investments from retained profits = 10%.

The estimated market value of equity share would therefore be:a €2.15 b €3.47 c €5.00 d €5.30

45 Broad Ltd and Oak Co both pay a constant dividend of $0·45 per share. Broad Ltd has a beta of1·5 and Oak Co has a beta of 1.2. The market share price of Broad Ltd is $4.50 and the marketshare price of Oak Co is $4.20.

The market rate of return is 10% and the risk free rate is 7%.

What would be the market price of shares of Broad Ltd and Oak Co using CAPM analysis?a Broad Ltd = $3.19; Oak Co = $4.42.b Broad Ltd = $3.91; Oak Co = $4.24.c Broad Ltd = $4.24; Oak Co = $3.91.d Broad Ltd = $4.50; Oak Co = $4.20.

46 Metro Co recently evaluated an investment project of 5 years with initial cash outlay has positiveannual net cash flows. The IRR and DPP methods for the appraisal of this project has been used.A further analysis revealed that the figure for cost of capital used was inappropriate as it ignoresthe cost of preference share capital and the correct figure should be higher.

What will be the possible effect on the IRR and DPP after using the correct cost of capital?a IRR = No change; DPP = No changeb IRR = Increase; DPP = Increasec IRR = Decrease; DPP = Decreased IRR = No change; DPP = Increase

47 Consider the following statements and determine which ONE (if any) is / are correct?(i) A beta factor in excess of 1.0, its expected returns are higher than the average returns for

the market as a whole.

(ii)

Individual securities will be either more or less risky than the market average in a fairlypredictable way. The measure of this relationship between market returns and anindividual security's returns, reflecting differences in systematic risk characteristics, can bedeveloped into a beta factor for the individual security.

a (i) and (ii) are correctb (i) is correct but (ii) is incorrectc (i) is incorrect but (ii) is correctd (i) and (ii) are incorrect


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52 Trout plc keeps ‘caviar’ in stock for which annual demand is 2000,000 kgs. The cost of placing anorder for the ‘caviar’ is $100 and the cost of holding one kg of ‘caviar’ is $1.00 per year. Trout plcuses the economic order quantity (EOQ) to derive the optimal order quantity for ‘caviar’. It can beassumed that demand for the item will remain constant throughout the year.

What is the annual cost of stock holding and stock ordering for ‘caviar’? a $10,000b $20,000c $30,000d $40,000

53 Consider the following statements:(i) Money cost of capital should be applied to estimated future cash flows after excluding

inflationary effect.(ii) Real cost of capital should be applied to estimated future cash flows after inclusion of

inflationary effect.

Which of the above statement (if any) is / are correct?a (i) onlyb (ii) onlyc Both (i) and (ii)d Neither (i) nor (ii)

54 Leo Ltd has 50 million $0·50 ordinary shares in issue. The total market value of these shares is$150 million. At the end of Leo Ltd’s fourth year of operation, after -tax profits were $20 millionand are expected to rise by 25% in the forthcoming year. Leo Ltd has a constant dividend payoutratio of 40% and intends to increase the dividend by 5% per year after payment of theforthcoming year’s dividend.

What is the expected rate of return (i.e. dividend yield) from the ordinary shares of Leo Ltd?a 5·10%b 10·33%c 11·67%d 15·00%

55 The following exchange rates of UK sterling (£) against the Japanese yen (¥) have been quoted:

Spot £1 = 170 ¥1 year forward, £1 = 162 ¥

The interest rate in Japan is 1% per year for a six-month deposit or borrowing.

What is the annual interest rate (approx.) for one year deposit or borrowing in the UK?a 6%b 7%c 8%d 9%


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56 A company is considering an investment in a capital project to increase output and sales of oneof its products, Product CBz. As a result of the investment, sales of Product CBz would rise by10,000 units each year. Relevant information for Product CBz is as follows:

$Selling price per unit 20Variable cost per unit 8Current fixed cost per unit 6

Fixed cost spending would rise from $600,000 each year to $680,000.

What would be the relevant annual cash flows when evaluating this project?a $40,000b $60,000c $80,000d $120,000

57 Noka plc had evaluated a new project using NPV and discounted payback method. The projectwas expected to provide substantial cash inflows, i.e. positive NPV, with DPP similar to company’sacceptable limit. However, a recent investigation by the financial manager revealed that thecompany’s cost of capital was higher than had been previously estimated.

What would be the effect on NPV and DPP taking account of the higher cost of capital?NPV DPP

a Increase Increaseb Increase Decreasec Decrease Increased Decrease Decrease

58 Wall Ltd is a manufacturer of fine-papers. Shares of Wall Ltd has a beta factor of 0.8. The averagemarket returns rose by 2% during the winter quarter. As a consequence of this change the actualreturn on shares of Wall Ltd should increase by 1.6% while the actual return was later establishedas an increase of 2.5%.

Which of the following would be more appropriate in explaining the differences between theactual returns (2.5%) and expected returns (1.6%)?a The difference between the actual change and expected change of 1.6% due to general

market factors would be attributed to unsystematic risk factors unique to Wall Ltd or to thepaper industry.

b The difference between the actual change and a change of 1.6% due to general marketfactors would be attributed to systematic risk factors unique to Wall Ltd or to the paperindustry.

c The difference between the market change and a change of 1.6% due to industrial factorswould be attributed to unsystematic risk factors unique to the company or to the paperindustry.

d The difference between the actual change and a change of 1.6% due to industrial factorswould be attributed to unsystematic risk factors unique to Wall Ltd or to the paper industry.


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59 Convertible loan stock is fixed return securities which can, at the option of the holder, beconverted into ordinary shares of the same company.

Which ONE of the following is not a benefit of convertible loan stock?a The issuing company can obtain finance at lower rates of interest.b It introduces an element of gearing, albeit short-term.c It can avoid redemption problems (cash flow)d It does dilute shareholder control initially.

60 Mr. Roger was recently appointed as assistant manager in the finance department of Jerq plc.During his 4 months period of job, he observed that the board of directors of Jerq plc used toraise finance by issuing convertible loan notes with lowest possible conversion premium.

Which of the following correctly explains the consequence of such practices by the board ofdirectors of Jerq plc?a Convertibles with the lowest possible conversion premium as this will mean that, for the

amount of capital raised, Jerq plc will, on conversion, have to issue the lowest number of newordinary shares.b Convertibles with the lowest possible conversion premium as this will mean that, for the

amount of capital raised, Jerq plc will, on conversion, have to issue the highest number ofnew ordinary shares.

c Convertibles with the lowest possible conversion premium as this will mean that, for theamount of capital raised, Jerq plc will, on conversion, have to issue the same number of newordinary shares.

d Convertibles with the lowest possible conversion premium as this will mean that, for theamount of capital raised, Jerq plc will, on conversion, have to issue the lowest number of newpreference shares.

61 Mr. Warren Buffet is a sole trader who makes packaging material for medicine. He has been inthis business for several years. Recently Mr. Warren asked his friend Mr. George Washington, achartered accountant, to examine his business accounts for he believes retained earnings werequite poor in relat ion to sales figures. Extracts from Mr. George’s report shows that during thepast two years, there was:

i. A rapid increase in sales revenue.ii. A rapid increase in the volume of current assets. Inventory turnover and receivables

turnover slowed down.iii. Only a small increase in Mr. Warren's capital. Most of the increase in assets is financed by

credit, especially: Trade payables

A bank overdraft, which often reaches or even exceeds the limit of the facilities agreed bythe bank.

Which of the above findings of Mr. George Washington are indications of overtrading by Mr.Warren Buffet?a (i) and (ii) onlyb (ii) and (iii) onlyc (i) and (iii) onlyd (i), (ii) and (iii)


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62 According to Modigliani and Miller the cost of equity will always fall with decreased gearingbecausea The firm is less likely to go bankruptb Debt is allowable against taxc The return to shareholders becomes less variabled The tax shield on debt increases the value of the shareholders' equity

63 According to Modigliani and Miller, if the tax relief on debt interest is ignored, the level of capitalgearing increases whena The cost of equity will decreaseb The value of the business will increasec The weighted average cost of capital will remain unchangedd The cost of debt capital will remain unchanged

64 What is the purpose of hedging?a To protect a profit already made from having undertaken a risky position

b To reduce costsc To reduce or eliminate exposure to riskd To make a profit by accepting risk

65 Which of the following is correct?a If interest rates rise, the market price of bond futures will fall.b If interest rates rise, the value of put options on bond futures will rise.c If interest rates rise, the coupon on a bond will fall.d If interest rates rise, the coupon on a bond will rise.

66 Which of the following is the best description of interest rate risk?a The risk from borrowingb The risk from not being able to meet interest payments on debt obligationsc The risk that interest rates will rised The risk to profit, cash flow or a company's valuation from changes in interest rates

67 Mawathir plc is a Malaysian company, trading in Europe and remitting profits to the Malaysia.The directors are considering methods that they can use to minimise their exposure to foreignexchange risk. Which of the following will not protect them from exchange risks?a Matchingb Forward contractsc Invoicing in European local currenciesd Leading and lagging

68 Which one of the following is not a feature of a capital market with 'strong form' efficiency?a Share prices change quickly to reflect all new information about future prospectsb Transaction costs are not significantc No individual dominates the marketd Individual share price movements can always be predicted from past price movements


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69 Dark plc has 200 million shares in issue, currently priced at $6 each on the stock market. It isplanning an investment costing $100 million, which would be financed by a mixture of retainedprofits and new debt capital. It has been estimated that the investment will have a net presentvalue of $120 million.

On 3rd April, the board of directors met to approve the capital expenditure. At the meeting, thecompany's advisers confirmed that the required debt capital would be available at the expectedcost.

On 10th April, the company made an announcement about the investment to the stock market.Investors welcomed the announcement and the estimated forecast of returns has been generallyaccepted as credible.

There are no other factors influencing the share price in this period. If the stock market displayssemi-strong form efficiency, what will be the share price after the events of 3rd April and 10thApril respectively?

a $6 per share after 3rd April and $6 per share after 10th Aprilb $6 per share after 3rd April and $6.10 per share after 10th Aprilc $6 per share after 3rd April and $6.60 per share after 10th Aprild $6.60 per share after 3rd April and $6.60 per share after 10th April

70 Agartala Co has recently made a tender offer of shares and received responses from differentbidders as follows:

Share Price $4.00 $3.25 $2.50 $1.75Number of shares at each share price (‘000) 850 950 1,100 1,200

What striking price is required to maximise receipts from the issue?a $3.35b $4.00c $2.50d $1.75

71 Cody Ltd uses the NPV approach in evaluating possible projects. Relevant data of a particularproject are given below for further evaluation.

% paCost of capital (real terms) 15Inflation expected 10The annual cash inflow to increase by 16

The annual cash outlay to increase by 12

Which of the following sets of adjustments will lead to the correct NPV being calculated?a Cash inflow and cash outflow to be unadjusted and discounted by 15% pab Cash inflow and cash outflow to be increased by 10% pa and discounted by 25% pac Cash inflow to be increased by 16% pa, cash outflow to be increased by 12% pa and both

discounted by 26.5% pad Cash inflow to be increased by 16% pa, cash outflow to be increased by 12% pa and both

discounted by 25% pa


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72 Asio Ltd is considering of investing in a project with positive cash flows, as expected by theproject specific director. The company uses discounted cash flow techniques in evaluating suchprojects and to apply a discount rate based on the real rate of return.

State when should a company like Asio Ltd use real rate of return as a basis for discount rate?a Real rate of return should be used if the cash flows are expressed in terms of the value of the

currency at time 0.b Real rate of return should be used if the cash flows are expressed in terms of the actual

number of currency that will be received or paid on the various future dates.c Real rate of return should be used if the cash flows are expressed in terms of changes in

inflation over the period of project’s life. d Real rate of return should be used if the cash flows are expressed without any inflationary

changes over the period of project’s life.

73 Bert plc is an equity financed mountain bicycle manufacturing company. It has 40 million ordinaryshares in issue and a market capitalisation of $78.4 million (ex-div). Extracts from its financial

statements for the year to 31 August 2010 are shown below:

$'000Profit before taxation 17,014Less: Corporation tax at 28% (4,764)Profit after taxation 12,250

The dividend payout ratio was 100%. Annual earnings and the dividend payout ratio have notchanged over the last few years and are expected to continue at present levels for theforeseeable future.

Which ONE of the following is the expected rate of return from the ordinary shares?a 21.7%b 15.6%c 6.4%d 4.6%

74 Lamia Plc has 50m $0.50 ordinary shares in issue with a total market capitalisation of $150m. Forthe year ended 20Y2 after-tax profits were $20m and are expected to rise by 25% in theforthcoming year. Lamia Plc has a steady dividend payout ratio of 40% and divided are to beincreased by 5% per year after payment of the forthcoming year’s dividend.

Identify the correct expected rate of return from the ordinary shares?

a 5.07%b 10.33%c 11.67%d 15.05%


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75 For some companies retained profits are an insufficient source of funds. The company might bemaking losses, and so might require new funds to restore its financial position. A company mighthave also plans for capital investment in excess of what it can finance 'internally' through retainedprofits. If so, it will need to raise extra finance usually from external sources. If it chooses to raisethe extra capital in the form of equity, it must issue new shares.

A new issue of ordinary shares might be made in a variety of circumstances.

Which ONE of the following is NOT a circumstance for issue of new ordinary shares?a To raise cash for major overhauling of factory building.b To raise more cash for investment.c To 'float' the company on the stock market.d To finance the takeover of another company.

76 Which ONE of the following is the correct definition of a ‘placing’? a A placing of shares involves an offer of shares to selected investors rather than to the general

public.b A placing of shares is an invitation to the general public to subscribe for shares not yet inissue.

c A placing of shares is an invitation to the general public to subscribe for shares already inissue.

d A placing of shares is a means of raising finance through an offer of shares to existingshareholders.

77 The following data has been obtained from Mr. Kerr, warehouse executive of Sand Co, in relationto product C19:

$The annual demand 40,000Cost of holding one unit for one year 2.50Cost of placing an order 20

It is assumed that demand for C19 will remain constant and Sand Co employs the economicorder quantity (EOQ) model to derive optimal order quantity for the item.

What is the combined annual cost of holding and ordering this item?a $8,250b $8,125c $3,000

d $2,000

78 A scrip issue with perfect informationa Decreases earnings per shareb Decreases the debt/equity ratio of the companyc Increases individual shareholder wealthd Increases the market price of the share


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79 ZZ is a manufacturing group serving the construction industry. Extracts from its incomestatements for 2009 and the previous year 2008, together with end-of-year statement of financialposition extracts, are as follows.

2009 2008$m $m

Sales revenue 2065 1,788.70Cost of sales 1479 1,304.00Gross profit 586 484.7Current assetsInventories 119 109Receivables (see note 1) 401 347.4Short-term investments 4 18.8Cash and cash equivalent 48 48

572 523.2

Current liabilitiesLoans and overdrafts 49 35.3Income tax payable 62 46.7Dividend payable 19 14.3Other (see note 2) 371 324

501 420.3

Net current assets 71 102.9

2009 2008Notes $m $m

1 Trade receivables 329.8 285.42 Trade payables 236.2 210.8

Calculate the cash cycle in each year, using the information available.2009 2008

a 29 30b 30 29c 29 29d 30 30


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80 A company's capital structure is as follows.

£m20m 50p ordinary shares 10Reserves 413% loan stock 20X4 7

21

The loan stock is redeemable at par in 20X4. Current market prices for the company's securitiesare: 50p ordinary shares, 280p; 13% loan stock 20X4, 100. The company is paying corporationtax at a rate of 28%. The cost of the company's equity capital has been estimated as 12% pa.

What is the company's per annum weighted average cost of capital for investment appraisalpurposes?a 12.1%

b 11.7%c 11.1%d 8.5%

81 Company should finance new investment opportunities, based on pecking order theory, in whichof the following order:

(I) Internal finance(II) External finance(III) Bonds(IV) Convertible bonds(V) Equitya (I), (II), (III), (IV), (V)b (I), (III), (II), (IV), (V)c (V), (IV), (III), (II), (I)d (I), (V), (III), (II), (IV)

82 The current US dollar/sterling spot rate is $1.50 to £1, and the dollar is at a premium againststerling for forward exchange contracts.

What would happen to the spot rate and forward rates if interest rates went up in the UK onsterling but not in the USA on the dollar?

Spot rate Forward premium

a Dollar would weaken Would increaseb Dollar would strengthen Would increasec Dollar would strengthen Would get smallerd Dollar would weaken Would get smaller


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83 The spot rate of exchange is £1 = $1.4400. Annual interest rates are 4% in the UK and 10% in theUS. The three-month forward rate of exchange should be:a £1 = $1.5231b £1 = $1.4616c £1 = $1.5264d £1 = $1.4614

84 The treasurer of Clark plc wishes to sell 200,000 Swiss francs that the company will receive inthree months' time from a customer in Berne. The SF/£ exchange rates are:

Spot 2.23 – 2.243 months forward 3.25 – 3c premium

If the company took out a forward exchange contract, what would it receive in sterling in 3months’ time from the exchange of its Swiss franc income? a £88,106

b £88,398c £90,498d £91,013

85 Calculate the interest rate per annum for a six-month deposit or borrowing in the US dollar($), based on the data provided below:

Exchange rates of US dollar ($) against the UK sterling (£) have been quoted:Spot $1 = £1.7574Six months’ forward = £1.7245

The interest rate in UK is 5% per year for a six-month deposit or borrowing.a 4.45%b 9.95%c 7.00%d 8.90%

86 The equity shares of Laird plc have a beta value of 0.90. The risk-free rate of return is 5% and themarket risk premium is 4%. Corporation tax is 25%. What is the required return on the shares ofLaird plc?a 7.7%b 8.1%c 8.6%

d 13.1%


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87 Calculate the expected cost and predicted value of an equity share in Shiny plc if its earnings pershare is $0.80 with a constant annual dividend payout ratio of 25%.

Note:

Shiny plc has equity beta of 1.2.The risk-free rate of return is 5%The market rate of return is 8%a Expected cost = 8.6%; Predicted value = $2.33b Expected cost = 20.6%; Predicted value = $3.88c Expected cost = 3.6%; Predicted value = $5.56d Expected cost = 8.6%; Predicted value = $9.30

88 Three-month sterling June futures are quoted on LIFFE at 93.50. Call options on three-monthsterling June futures at 93.00 are quoted at 0.66. This premium of 0.66 representsa 0.66 intrinsic valueb 0.66 time value

c 0.50 intrinsic value and 0.16 time valued 0.16 intrinsic value and 0.50 time value

89 It is now mid-August. In about two or three months' time Gear plc will need to borrow £6,000,000for six months and wishes to obtain protection against the possibility of rising interest rates. Gearplc has been advised to sell the 'three-month sterling' £500,000 interest rate contracts traded onLIFFE.

Gear plc should:a Sell 24 of the December contractsb Sell 12 of the December contractsc Sell 24 of the September contractsd Sell 12 of the September contracts

90 State which of the following is correct:

(I) An European-style option gives the right to its holder to exercise the option on a specificfuture date(II) An American style option gives the right to its holder to exercise the option at any timeup to and including a specific future expiry datea (I) is correct but (II) is incorrectb (I) is incorrect but (II) is correctc Both (I) and (II) are correct

d Both (I) and (II) are incorrect


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91 The supplier of Stream plc has offered a credit terms of 3/15 net 40. Stream plc had purchasedgoods amounting $12,000 from this supplier 2 days earlier.

Stream plc is considering whether to take the advantage of cash discount with payment made onthe last possible day. The opportunity cost of funds for Stream plc is 30%.

What is the net saving or cost at the normal time of payment of taking a cash discount?a Net saving $123b Net cost $32c Net saving $121d Net cost 114

92 In three months' time you will have £6 million to put on deposit for four months. You areconcerned that interest rates will fall and wish to arrange an FRA to hedge the risk and fix aneffective interest rate for the future deposit. What will you do to hedge the exposure?a Sell a 3 – 7 FRA

b Sell a 3 – 4 FRAc Buy a 3 – 4 FRAd Buy a 3 – 7 FRA


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S OLUTION

1 B2 C3 C4 A5 B6 D7 D Re-order level

20 (max Usage) x 6 (max lead time) 120Add: Buffer inventory 40

160Less: 1 (min usage) x 5 (min lead time) (5)

Inventory held when fresh deliveries are made 155Add: Re-order quantity (EOQ) 45

The maximum number of units held its therefore 2008 B9 C10 B11 C12 C13 D14 B15 C16 C17 A18 B19 A20 C21 C22 C23 A24 C25 C26 C27 B28 D29 D30 D31 D Dividend = ($12m x 1.25)/1.5 = $10m

Using the dividend growth model:Ke = (D1/Po) + g= (10.0/60.0) + 0.04= 20.7


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32 A $Cost of warrant 0.50Exercise price 2.50

3.00Current share price 2.25Premium 0.75

33 C centsCost of warrant 68Exercise price 780

848Current share price (762)Premium 86

34 A Re-order level = 30 x 35 = 1,050 unitsAverage usage = 22 x 30 = 660 unitsAverage buffer inventory = 1,050 – 660 = 390 unitsMax. level of inventory = 1,000 + 1,050 – (16 x 20) = 1,730 units

35B MV per share ex div = $5.5 – 0.5 = $5.00EPS = $0·5 x 100/20 = $2.5

P/E ratioMV per share ex div = $5.00/$2.5EPS = 2.0 times

36 B37 B38 B39 D40 C (i) Exercise. Mr. Orsi can sell the shares (put option) at 545c when the market price

is just 510c. Mr. Orsi will make a gain of 35c per share on the 6,000 shares.(ii) Allow the option to lapse. Mr. Orsi can buy the shares in the market at 330c, and

will not want to exercise the right to buy them at 378c, ie for 48c per share more.(iii) Exercise. Mr. Orsi can buy €500,000 (call option) for $450,000 at 0.9000 by

exercising the option, when it would cost Mr. Orsi (× 0.9500) $475,000 to buy theeuros in the spot currency market. Mr. Orsi’s gain will be $25,000.

(iv) Exercise. Mr. Orsi can sell the £250,000 for (× 1.4500) $362,500 by exercising theput option, when Mr. Orsi would only receive (× 1.4100) $352,500 by sellingthem in the spot currency market. Mr. Orsi’s gain will be $10,000.

(v) Exercise. It is cheaper to exercise the option and borrow at 5% than to borrow atthe current market rate of 5.6%.

41 D42 A The cost of debt capital: 4% x (20·0/10·0) x (1 – 0·25) = 6·0%

WACC:10% = [(10/40) x 6·0%] + [(30/40) x K eg%]0·75 Keg = 8·5%Keg = 11·3%

43 D44 D The annual rate of growth in future dividends – g = bR is 10% x 60% = 6%

Using the dividend growth model, the expected market value of each share is:Po = Do(1 + g)/(r – g)


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Po = 0·20(1 + 0·06)/0·10 – 0·06) = €5·30 45 B46 D47 A48 A49 C50 C51 B52 C53 D54 C Share price = $150m/50m = $3·00

Dividend per share = ($20m x 1·25) x 0·4/50m = $0·20Expected return = (20/300) + 0·05= 11·67%

55 A An investor could invest in Japanese ¥ at 1% or invest in UK£.¥

Assume £100 is converted to ¥ at spot 17,000Invested at 1·0% for 1 year 17017,170

Converted to UK£ at the forward rate (¥17,170/$162) = £105.98 or £106Interest rate is 6% per year.

56 A It is assumed that all relevant costs are variable costs.Net cash flow

$Increase in sales 10,000 × $20 200,000Increase in variable costs 10,000 × $8 (80,000)Increase in annual contribution 120,000Increase in fixed cost spending (80,000)Increase in annual cash profits 40,000

57 C Higher cost of capital will decrease the present value of cash inflows, which will in turndecrease the NPV and increase the discounted payback period.

58 A59 D It does not dilute shareholder control initially.60 B61 D62 C The return to shareholders becomes less variable when gearing is lower.63 D64 C

65 A66 D If interest rates rise, the market price of bonds will fall, and so the price of bond futureswill also fall. Call options on bond futures will increase in value and put options on bondfutures will fall in value. The coupon rate of a bond is unaffected by rises or falls ingeneral interest rates.


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67 C Leading and lagging means advancing or delaying payments to a time when theexchange rate is favourable. Matching receipts and payments in the same currencyreduces the need to convert currencies. Forward contracts hedge against changes inexchange rate and provide certainty in conversion. Invoicing in local currency means thatprofits are held in local currency. Remitting these profits to the UK will then be open toexchange risk.

68 D The market will consider information about the company's future prospects, which donot depend on how it has performed in the past.

A is not correct as the key to market efficiency is the availability and processing ofinformation. If all relevant information is easily available to all investors, and investorsrespond to information in a rational way, then share prices will move quickly to reflectthis information in a logical manner.

B is not correct as the transaction costs of buying and selling should not be so high as to

discourage trading significantly.

C is not correct as the market should be large enough so that no one individual can, byhis actions, affect the movement of the market.

69 C The correct answer is: $6 per share after 3rd April and $6.60 per share after 10th April.When a market displays semi-strong form efficiency, share prices react both toannouncements about historical results and also to information such as companyannouncements. On 3rd April, nothing is disclosed to the stock market, so there will beno change in the share price. When the announcement is made on 10th April, the sharesshould increase by the NPV of the investment, i.e. by $120 million or $0.60 per share.

70 C71 C Money cost of capital: (1.15 x 1.1) – 1 = 26.5%.72 A73 B Bert’s cost of capital: Divid ends / market capitalisation = $40.78m/$25.12m = 15.625%.74 C75 A76 A77 D78 A It increases the number of shares without affecting the value of the company, so market

price per share and earnings per share will fall.


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79 A 20X3 20X4Receivablescollection period

329.8/2065.0x365= 58 days

285.4/1788.7x365= 58 days

Inventoryturnover period

119.8/2,065.0x365= 29 days

109.0/1304.0x365= 31 days

Payablespayment period

236.2/1,478.6x365= 58 days

210.8/1,304.0x365= 59 days

Cash cycle (58 + 29 – 58)= 29 days

(58 + 31 – 59)= 30 days

The company is a manufacturing group serving the construction industry, and so mightbe expected to have a comparatively lengthy receivables' collection period, because ofthe relatively poor cash flow in the construction industry. It is clear that the companycompensates for this by ensuring that they do not pay for raw materials and other costs

before they have sold their inventories of finished goods (hence the similarity ofreceivables and payables turnover periods).80 B kd = coupon rate × (1 – T) for redeemable debt standing at par in the market and

redeemable at par.

kd = 13 × (1 – 0.28) = 9.36%ke = 12%ke = EKe + DKd / (E + D) = (20m x £2.80 x £7m x 9.36%)/(20m x £2.80+£7m)

=11.7%81 A82 A The increase in UK interest rates would strengthen sterling against the dollar at the spot

rate, because sterling becomes a more attractive currency to buy and invest in.The forward rate premium is measured approximately by(1+US dollar interest rate)/(1+sterling interest rate)

So, for example, if US interest rates are 9%, and UK rates went up from 14% to 15%, theforward rate would change from 1.09/1.14 = 0.956 to 1.09/1.15 = 0.948 of the spot rate.The premium would increase from 0.044 (4.4% of the spot rate) to 0.052 (5.2% of thespot rate).

83 D £1 invested now for three months will accumulate to £1.01 (+ (£1 × 0.04 × 1/4))$1.44 invested now for three months will accumulate to $1.476(s+ ($1.44 × 0.10 ×1/4))Three-month forward rate will equate these two figures = 1.476/1.01 = £1 = £1.4614

84 C 200,000 / (2.24 – 0.03) = £90,498

If you chose £91,013, you used the rate at which Clark plc would buy Swiss francs.If you chose £88,398, you used the rate at which Clark plc would buy Swiss francs andadded the premium rather than subtracting it.

85 D86 C Return per CAPM = Rf + β(Rm – Rf)

Return = 5% + (0.90 × 4%) = 8.6%Note: market risk premium = (Rm – Rf)

87 A


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88 C The option is in-the-money, because an investor could exercise the call to buy a future at93.00 and sell the future at 93.50, a gain of 0.50. The intrinsic value of an option is theamount by which it is in-the-money. The intrinsic value is therefore 0.50 and the rest ofthe premium must be its time value.

89 A The loan will need to be taken out in October/November for 6 months thereforeDecember futures would be most appropriate. Since the loan is for 6 months the numberof three-month futures required will be double the number based upon value.Number of contracts required = £6,000,000 / £500,000 × 6/3 = 24 contracts

90 C91 C92 A To fix a rate for interest income, you should sell an FRA. An FRA for a four-month interest

period starting at the end of three months is a 3 – 7 FRA.

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