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F9:
Financial Management
1) Which of the following statements is/are correct?
(1) Monetary policy seeks to influence aggregate demand by increasing or decreasing the money
raised through taxaCon
(2) When governments adopt a floaCng exchange rate system, the exchange rate is an
equilibrium between demand
and supply in the foreign exchange market
(3) Fiscal policy seeks to influence the economy and economic growth by increasing or decreasing
interest rates
A 2 only B 1 and 2 only C 1 and 3 only D 1, 2 and 3
2) Which of the following statements are correct?
(1) The general level of interest rates is affected by investors’ desire for a real return
(2) Market segmentaCon theory can explain kinks (disconCnuiCes) in the yield curve
(3) When interest rates are expected to fall, the yield curve could be sloping downwards
A 1 and 2 only B 1 and 3 only C 2 and 3 only D 1, 2 and 3
3) Which of the following statements is correct?
A One of the problems with maximising accounCng profit as a financial objecCve is that
accounCng profit can be
manipulated
B A target for a minimum level of dividend cover is a target for a minimum dividend payout raCo
C The welfare of employees is a financial objecCve
D One reason shareholders are interested in earnings per share is that accounCng profit takes
account of risk
1) 13/30=43% 13,2/31,8=41% 13,3/33,69=39% 15/35,7= 42$
13,2/13-‐1=1,5% 13,3/13,2-‐1=0,75% 15/13,3-‐1=12,7 average= 5%
0,15/12,25+(2,25-‐2.01)/2.01=18,6%
Mean growth in earnings per share = 100 x [(35·∙7/30·∙0)1/3 – 1] = 5·∙97% or 6%

Which of the following statements is NOT correct?
A Return on capital employed can be defined as profit before interest and tax divided by the sum of
shareholders’ funds and prior charge capital
B Return on capital employed is the product of net profit margin and net asset turnover
C Dividend yield can be defined as dividend per share divided by the ex dividend share price
D Return on equity can be defined as profit before interest and tax divided by shareholders’ funds
Which of the following statements are correct?

(1) The sensiCvity of a project variable can be calculated by dividing the project net present
value by the present value of the cash flows relaCng to that project variable
(2) The expected net present value is the value expected to occur if an investment project with
several possible outcomes is undertaken once
(3) The discounted payback period is the Cme taken for the cumulaCve net present value to
change from negaCve to posiCve
Which of the following statements is/are correct?
(1) The asset beta reflects both business risk and financial risk
(2) Total risk is the sum of systemaCc risk and unsystemaCc risk
(3) Assuming that the beta of debt is zero will understate financial risk when ungearing an
equity beta
A 2 only
B 1 and 3 only
C 2 and 3 only
D 1,2 and 3

(1) Share opCon schemes always reward good performance by managers
(2) Performance-‐related pay can encourage dysfuncConal behaviour
(3) Value for money as an objecCve in not-‐for-‐profit organisaCons requires the pursuit of
economy, efficiency and
EffecCveness
Which of the following are financial intermediaries?
(1) Venture capital organisaCon
(2) Pension fund
(3) Merchant bank
A 2 only
B 1 and 3 only
C 2 and 3 only
D 1,2 and 3
A company has in issue loan notes with a nominal value of $100 each. Interest on the loan notes is
6% per year, payable annually. The loan notes will be redeemed in eight years’ Cme at a 5%
premium to nominal value. The before-‐tax cost of debt of the company is 7% per year.
What is the ex interest market value of each loan note?
A $94·∙03
B $96·∙94
C $102·∙91
D $103·∙10
Answer:
Market value = (6 x 5·∙971) + (105 x 0·∙582) = 35·∙83 + 61·∙11 = $96·∙94
FM4(7%,8 years)=5,971 FM2 (7%,8 years)= 0,582
Which of the following statements is correct?
A One of the problems with maximising accounCng profit as a financial objecCve is
that accounCng profit can be manipulated
B A target for a minimum level of dividend cover is a target for a minimum dividend
payout raCo
C The welfare of employees is a financial objecCve
D One reason shareholders are interested in earnings per share is that accounCng
profit takes account of risk

(1) Capital market securiCes are assets for the seller but liabiliCes for the buyer
(2) Financial markets can be classified into exchange and over-‐the-‐counter markets
(3) A secondary market is where securiCes are bought and sold by investors
A 1 and 2 only B 1 and 3 only C 2 and 3 only D 1,2 and 3
(1) A cerCficate of deposit is an example of a money market instrument
(2) Money market deposits are short-‐term loans between organisaCons such as banks
(3) Treasury bills are bought and sold on a discount basis

(1) Interest rate opCons allow the buyer to take advantage of favourable interest rate
movements
(2) A forward rate agreement does not allow a borrower to benefit from a decrease in interest
rates
(3) Borrowers hedging against an interest rate increase will buy interest rate futures now and
sell them at a future
date

(1) If a capital market is weak form efficient, an investor cannot make abnormal returns by
using technical analysis
(2) OperaConal efficiency means that efficient capital markets direct funds to their most
producCve use
(3) Tests for semi-‐strong form efficiency focus on the speed and accuracy of share price
responses to the arrival of
new informaCon

On a market value basis, GFV Co is financed 70% by equity and 30% by debt. The company has an
amer-‐tax cost of debt of 6% and an equity beta of 1·∙2. The risk-‐free rate of return is 4% and the
equity risk premium is 5%.
What is the a>er-‐tax weighted average cost of capital of GFV Co?
A 5·∙4%
B 7·∙2%
C 8·∙3%
D 8·∙8%

Cost of equity = 4 + (1·∙2 x 5) = 4 + 6 = 10%
WACC = (10 x 0·∙7) + (6 x 0·∙3) = 7 + 1·∙8 = 8·∙8%

Net asset value (NAV) = 140m – 15m – 20m = $105m
Number of ordinary shares = 25m/0·∙5 = 50m shares
NAV per share = 105m/50m = $2·∙10 per share

Calculate the market price of the converDble loan notes of Par Co, commenDng on
whether conversion is likely.
Calculate the share price of Par Co using the price/earnings raDo method and discuss
the problems in using this method of valuing the shares of a company.
•  Average historical share price growth = 100 x ((10·∙90/9·∙15)^1/3 – 1) = 6% per year
•  Future share price amer 7 years = 10·∙90 x 1·∙06^7 = $16·∙39 per share
•  Conversion value of each loan note = 16·∙39 x 8 = $131·∙12
•  The investor is faced with the choice of redeeming the loan notes at their nominal value of $100 or
converCng them into shares worth $131·∙12. The raConal choice is to maximise wealth by taking the
conversion opCon.
•  Market value of each loan note = (8 x 5·∙033) + (131·∙12 x 0·∙547) = 40·∙26 + 71·∙72 = $111·∙98
•  _______________________________________________________
The average price/earnings raCo (P/E raCo) of listed companies similar to Par Co has been recently
reported to be 12 Cmes and the most recent earnings per share (EPS) of Par Co is 62 cents per share.
The share price calculated using the P/E raCo method is therefore $7·∙44 (12 x 62/100).
One problem with using the P/E raCo valuaCon method relates to the selecCon of a suitable P/E raCo.
The P/E raCo used here is an average P/E raCo of similar companies and Par Co is clearly not an average
company, as evidenced by its year-‐end share price being $10·∙90 per share, some 47% more than the
calculated value of $7·∙44. The business risk and financial risk of Par Co will not be exactly the same as
the business risk and financial risk of the similar companies, for example, because of diversificaCon of
business operaCons and differing capital structures. Par Co may be a market leader or a rising star
compared to similar companies.

Gemlo Co is planning an expansion of exisCng business operaCons cosCng $10 million in the near future
and is assessing its current financial posiCon as part of preparing a business case in support of seeking
new finance. The business expansion is expected to increase the profit before interest and tax of Gemlo
Co by 20% in the first year.
The planned business expansion by Gemlo Co has already been announced to the stock market.
InformaCon on the expected increase in profit before interest and tax has not yet been announced and
the company has not decided on how the expansion is to be financed.
The ordinary shares of the company are currently trading at $3·∙75 per share on an ex dividend basis. The
irredeemable loan notes have a cost of debt of 7%. The 7% loan notes have a cost of debt of 6% and will
be redeemed at a 5% premium to nominal value amer seven years. The interest cover of Gemlo Co is 6
Cmes.
Companies operaCng in the same business sector as Gemlo Co have an average debt/equity raCo of 40%
on a market value basis and an average interest cover of 9 Cmes.
Required:
(a) Calculate the debt/equity raDo of Gemlo Co based on market values and comment on your findings.
•  Gemlo Co agrees with a bank that its business expansion will be financed
by a new issue of 8% loan notes. The company then announces to the
stock market both this financing decision and the expected increase in
profit before interest and tax arising from the business expansion.
•  Required:
•  Assuming the stock market is semi-‐strong form efficient, analyse and
discuss the effect of the financing and profitability announcement on the
financial risk and share price of Gemlo Co.
•  If the stock market on which Gemlo Co is listed is semi-‐strong form efficient, share prices on the
stock market will quickly and accurately react to the release of new informaCon. The stock
market will have already factored the informaCon about the proposed business expansion into
the share price of the company. The announcement that the business expansion will be financed
by a $10 million issue of 8% loan stock is new informaCon, as is the announcement of the
expected increase in profit before interest and tax (PBIT) of 20% in the first year. The effect of the
announcements on the share price of Gemlo Co will depend on how the stock market interprets
this new informaCon.
•  Interest cover
•  The informaCon about the financing choice indicates that annual interest will increase by $0·∙8
million (8% x $10m) from $1·∙44 million (6% x $10m + 7% x $12m) to $2·∙24 million. The stock
market knows that Gemlo Co currently has interest cover of 6 Cmes and hence PBIT of $8·∙64
million (6 x $1·∙44m). Amer the business expansion, PBIT is expected to increase by 20% to
$10·∙368 million ($8·∙64m x 1·∙2) in the first year. The interest cover of Gemlo Co is therefore
expected to fall to 4·∙6 Cmes ($10·∙368m/$2·∙24m).
•  The stock market will note that the interest cover of Gemlo Co, which at 6 Cmes is already below
the average interest cover of 9 Cmes of companies in the same business sector, will fall further
below the average interest cover to 4·∙6 Cmes.
•  Debt/equity raDo
•  The total market value of debt would increase from $21·∙639 million to $31·∙639 million. If the
market value of equity remains unchanged, the market value debt/equity raCo increases from
38·∙5% to 56·∙3% (100 x 31,639,000/56,250,000). From being slightly less than the average debt/
equity raCo of 40% of companies in the same business sector, therefore, the debt/equity raCo of
Gemlo Co would be 41% above it in relaCve terms.
Task 3

Using the informaDon in the table, calculate Ramsey's WACC at 31 August 20X7.
Investment 2
Ramsey's board is considering a major change in strategy by invesCng in the development of
driverless cars. A driverless car is a vehicle that is capable of sensing its environment and
navigaCng without human input. The finance for this investment would be raised in such a way
so as not to alter Ramsey's current gearing raCo (measured as debt:equity by market values). The
debt element of the finance will come from a new issue of 9% irredeemable debentures at par.
Ramsey's directors want to establish a cost of capital that could be used to appraise the
investment in driverless cars. They are aware that such a diversificaCon would be very risky and
is likely to increase Ramsey's equity beta which is currently 1.25.
The following data, collected at 31 August 20X7, should be used when preparing your workings
for the next board meeCng:
Driverless cars industry sector
Equity beta 2.10
RaCo of long-‐term funds (debt:equity) by market values 16:72
Expected risk free rate 2.25%
Expected return on the market 9.15% pa

Other informaDon
You should assume that corporaCon tax will be payable at the rate of 17% for the foreseeable
future and tax will be payable in the same year as the cash flows to which it relates.
Calculate an appropriate WACC that Ramsey could use when appraising Investment 2 (leverage
for cost of capital = total capital/equity)

WACC = (18.05% ︎ £65.6m/£86.6m) + (7.47% ︎ £21.0m/£86.6m)) = 15.48%

It would be unwise to use the exisCng WACC (9.91%) as Ramsey’s plan involves diversificaCon,
and therefore a change in the level of systemaCc risk (beta rises to 2.29 from 1.25). Thus a new
WACC must be calculated. SystemaCc risk is accounted for by taking into account the beta of the
driverless cars market, and this is then adjusted to eliminate the financial risk (level of gearing) in
that market. The resultant ungeared beta is then “re-‐geared” by taking into account the level of
gearing of the new funds being raised.
The finance director of Liteform plc (Liteform) has been asked to calculate a discount factor for use in appraising all the
firm's potenCal investment projects in the forthcoming year. He has gathered the following informaCon, which he has
passed on to you, the firm's finance manager, with the request that you use the informaCon provided to calculate the
firm's weighted average cost of capital, which will then be used as the required discount factor.
(1) The current cum-‐dividend price of a Liteform ordinary share is £4.58 and an annual dividend of £1,134,000 is due to
be paid in the near future. Dividends have represented a constant proporCon of profits amer interest and tax over the
last few years.
(2) The current price of the firm's loan stock is £85.10 per £100 of stock. The loan stock is redeemable in ten years' Cme
at a premium of 5% compared to the nominal value of the loan stock. Annual interest on the loan stock has just been
paid.
(3) The current rate of corporaCon tax is 17% and the current basic rate of income tax is 20%.
(4) Extracts from Liteform's most recent financial statements:

•  Using the informaDon provided, calculate Liteform's weighted average cost of capital
(WACC).
•  Discuss the underlying assumpDons and weaknesses of the approach you have employed
in calculaDng the cost of equity
1. The Gordon Growth Model:
In its use of ARR, it relies upon accounCng profit figures as opposed to
cash-‐flows
It assumes that both r and b will remain constant
ARR can be distorted by inflaCon if assets remain valued at historic cost
The model assumes all new finance comes from equity (or gearing
remains constant)
2. The Dividend ValuaDon Model:
The model assumes that the value of shares derives solely from dividends,
which is untrue The model assumes either that dividends do not grow or
will grow at a constant rate
The model assumes share prices are constant, but they are subject to
constant fluctuaCon The model ignores future income growth
Calculate the market value weighted average cost of capital of AMH Co.
GXG Co is an e-‐business which designs and sells computer applicaCons (apps) for mobile phones. The company
needs to raise $3,200,000 for research and development and is considering three financing opCons.
OpDon 1
GXG Co could suspend dividends for two years, and then pay dividends of 25 cents per share from the end of
the third year, increasing dividends annually by 4% per year in subsequent years. Dividends in recent years
have grown by 3% per year.
OpDon 2
GXG Co could seek a stock market lisCng, raising $3·∙2 million amer issue costs of $100,000 by issuing new
shares to new shareholders at a price of $2·∙50 per share.
OpDon 3
GXG Co could issue $3,200,000 of bonds paying annual interest of 6%, redeemable amer ten years at par.
Recent financial informaCon relaCng to GXG Co is as follows:
Required:
(a) Using the dividend valuaDon model, calculate the value of GXG Co under opDon 1, and advise whether opDon 1 will be acceptable
to shareholders.)
(b) Calculate the effect on earnings per share of the proposal to raise finance by a stock market lisDng (opDon 2), and comment on
the acceptability of the proposal to exisDng shareholders.
(c) Calculate the effect on earnings per share and interest cover of the proposal to raise finance by issuing new debt (opDon 3), and
comment on your findings.
1) The dividend growth model can give a value of GXG Co at the end of the second year
of not paying dividends, based on the dividends paid from the end of the third year
onwards. The company has 10 million shares in issue ($5 million/50 cents nominal value)
and so the total dividend proposed at the end of the third year will be $2·∙5 million (25
cents per share x 10m). If these dividends increase by 4% per year in subsequent years,
their capital value at the end of the second year will be:
2·∙5/(0·∙09 – 0·∙04) = $50 million
The dividend valuaCon model value (the capital value of the dividends at year 0) will be:
50/1·∙09^2 = $42·∙1 million
The current present value of dividends to shareholders, using the exisCng 3% dividend
growth rate:
(1·∙6 x 1·∙03)/(0·∙09 – 0·∙03) = $27·∙5 million
The proposal will increase shareholder wealth by 42·∙1 – 27·∙5 = $14·∙6 million and so is
likely to be acceptable to shareholders.

2) The cash to be raised = 3,200,000 + 100,000 = $3,300,000
The number of shares issued = 3,300,000/2·∙50 = 1,320,000 shares Total number of shares
amer the stock market lisCng = 11,320,000 shares
Increase in before-‐tax income = 0·∙18 x 3·∙2m = $576,000 Increase in amer-‐tax income =
576,000 x 0·∙8 = $460,800 Revised earnings = 2,600,000 + 460,800 = $3,060,800
Revised earnings per share = 100 x (3,060,800/11,320,000) = 27 cents per share Current
earnings per share = 100 x (2,600,000/10,000,000) = 26 cents per share

3) Increase in before-‐tax income = 0·∙18 x 3·∙2m = $576,000 Revised operaCng profit =
576,000 + 3,450,000 = $4,026,000
Interest on new debt = 3,200,000 x 0·∙06 = $192,000 Revised interest = 192,000 +
200,000 = $392,000
Revised profit before tax = 4,026,000 – 392,000 = $3,634,000 Revised profit amer tax =
3,634,000 x 0·∙8 = $2,907,200
Revised earnings per share = 100 x (2,907,200/10,000,000) = 29·∙1 cents per share
Earnings per share would increase by 3·∙1 cents per share.
Current interest cover = 3,450,000/200,000 = 17 Cmes Revised interest cover =
4,026,000/392,000 = 10 Cmes

The increase in earnings per share would be welcomed by shareholders, but further
informaCon on the future of the company following the investment in research and
development would be needed for a more comprehensive answer. The decrease in
interest cover is not serious and the increase in financial risk is unlikely to upset
shareholders.

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F9:

Which of the following statements are correct?

Which of the following statements are correct?

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