Professional Documents
Culture Documents
1. Fitz Frazel Co has just paid a dividend of 25c per share for the year just ended out of earnings per share of 41c. Its
share price is $3.80 per share. One year ago, Fitz Frazel Co made earnings per share of 33c and the price/earnings
ratio was 10.
What is the total shareholder return over the period just ended?
A. 15.2%
B. 13.2%
C. 22.7%
D. 19.7%
Shareholder return = (current DPS + changes in Share Price)/ last year share price
DPS = $0.25
Current EPS = $0.41
Current share price = $3.80
Last year’s EPS = $0.33
P/E ratio = Share price / EPS or Market capitalization/Total earnings
P/E ratio = 10
Last year’s share price = 10 x $0.33 = $3.30
This year share price = $3.80 less $3.30 = 50c change in share price.
TSR = Dividend + Change in share price / last year share price
= 0.25 + 0.5 / 3.30 = 22.7%
2. The government of a modern industrialised economy has adopted the following measures.
A. 1 only
B. 1 and 2 only
C. 2 and 3 only
D. 3 only
What is the economic order quantity for Product Z to the nearest 1,000 units?
A. Zero units
B. 1,000 units
C. 11,000 units
D. 38,000 units
4. Hawns Co uses Miller-Orr to control its cash balances. It has a lower limit of $5,000 and a spread of $18,000.
Which of the following statements are consistent with the use of Miller-Orr?
1. When cash balances rise to $18,000, Hawns Co buys $8,666 of short-term securities
2. When cash balances fall to $5,000, Hawns Co sells $6,000 of short-term securities
A. 1 only
B. 2 only
C. Both 1 and 2
D. Neither 1 nor 2
A. None of these
B. All of these
C. 1 only
D. 2 and 3 only
Statement 1 is not true. Payback period tends to favour short-term projects and therefore minimizes financial and
business risk.
Statement 2 is untrue. It is simple to understand.
Statement 3 is not true because payback period helps to identify those projects which generate additional cash for
investment quickly.
C6: Allowing for tax, working capital and inflation
6. AW Co needs to have $100,000 working capital in place immediately for the start of 2- year project. The amount
will stay constant in real terms. Inflation is running at 10% per year, and AW Co's money cost of capital is 12%.
A. $(21,260)
B. $(20,300)
C. $(108,730)
D. $(4,090)
The working capital required will inflate year on year, then the inflated amount will be ‘returned’ at the end of the project.
7. AZ Yet Co financial year end is on 31 September. On 1 October 2020 a new machine costing $2,000,000 is
purchased. The company expects to sell the machine on 31 September 2022 for $500,000. Tax allowable
depreciation is obtained at 25% on the reducing balance basis and a balancing allowance is available on disposal
of the asset. The effective rate of corporation tax for the company is 35% and is paid one year in arrears. AZ Yet
Co makes sufficient profits to obtain relief for tax allowable depreciation as soon as they arise.
If the company's cost of capital is 10% per annum, what is the present value of the tax allowable depreciation
(to the nearest $1,000)?
A. $525,000
B. $407,000
C. $432,000
D. $448,000
Y0 2,000,000
TAD (500,000) x 35% = 175,000 (Y2)
CV 1,500,000
SV 500,000
BA 1,000,000 x 35% = 350,000 (Y3)
Tax flows 12 months after end of AP means first tax saving by capital allowances in Time 2 (claimed Time 1).
PV = (500,000 x 0.35 x 0.826) + (1,000,000 x 0.35 x 0.751) = 407,400
C9: Sources of finance
8. Jon and Majid have entered into a Sharia’s compliant partnership contract whereby Jobling and Majid both
contribute capital and expertise in equal proportion. They have agreed that profits from the partnership will be
shared in a ratio of 65:35 in favour of Jon. The partnership has made a loss of $10,000.
A. Nil
B. $5,000
C. $3,500
D. $10,000
The following statements have been made in relation to Derby Co's dividend policy.
1. The company is pursuing a dividend policy consistent with Modigliani and Miller's irrelevancy theory.
2. The company's total dividend payout has fallen between 20X7 and 20X9.
A. 1 only
B. 2 only
C. Both 1 and 2
D. Neither 1 nor 2
1. They proposed that the dividend policy of a company has no effect on the stock price of a company or the
company’s capital structure. (no information to verify)
10. Four companies are identical in all respects, except for their capital structures, which are as follows:
The equity beta of A plc is 0.89 and the equity beta of D plc is 1.22.
Within which ranges will the equity betas of B plc and C plc lie?
A. The beta of B plc and the beta of C plc are both higher than 1.22.
B. The beta of B plc is below 0.89 and the beta of C plc is in the range 0.89 to 1.22.
C. The beta of B plc is above 1.22 and the beta of C plc is in the range 0.89 to 1.22.
D. The beta of B plc is in the range 0.89 to 1.22 and the beta of C plc is higher than 1.22.
The companies are identical except for their gearing and the beta factor of equity shares will increase with the gearing
level. The beta of B plc (gearing 80%) is therefore higher than the beta for D plc (gearing 60%), i.e. over 1.22. The beta
of C plc (gearing 35%) is higher than the beta for A plc (gearing 30%) and below the beta for D plc. It must therefore be
in the range 0.89 to 1.22.
'Debt is cheaper than equity': Although true, higher gearing increases the cost of equity (financial risk) therefore this
doesn't in itself explain a reducing WACC.
'Interest payments are tax deductible' is correct: The only difference between MM (no tax) and MM (with tax) is the tax
deductibility of interest payments. MM demonstrated that when a business does not pay tax, returns are not affected by
capital structure. However, as interest is tax deductible (and dividends are not), paying relatively more interest will
reduce tax payable and increase total returns to investors.
'Reduced levels of expensive equity capital will reduce the WACC' is similar to Statement A.
'Financial risk is not pronounced at moderate borrowing levels' refers to the traditional view. MM assume financial risk is
consistently proportionate to gearing across all levels.
C14: Foreign currency risk
12. Which of the following derivative instruments are characterised by a standard contract size?
1. Futures contract
2. Exchange-traded option
3. Forward rate agreement
4. Swap
A. 1 and 2
B. 2 and 3
C. 3 and 4
D. 1 and 4
Derivative hedging instruments that are traded on an exchange or market are standardised in nature. Futures contracts,
whether interest rate futures or currency futures, relate to a standard quantity of an underlying asset. Exchange-traded
options, by definition, are traded on an exchange and are therefore standardised in nature, whether interest rate options
or currency options. A forward rate agreement (FRA) is the interest rate equivalent of a forward exchange contract
(FEC). It is an agreement between a bank and a customer to fix an interest rate on an agreed amount of funds for an
agreed future period. The FRA is tailored to the customer's needs and so is a bespoke contract rather than a
standardised contract. Answers B and C were therefore not correct.
Both currency swaps and interest rate swaps are derivatives that are available to organisations to manage or hedge
long-term foreign currency risk and interest rate risk. They are essentially an agreement between two counter parties to
exchange interest rate obligations on an agreed amount of funds, whether in the domestic currency or in a foreign
currency. A bank will usually act as an intermediary in arranging a swap in exchange for a fee and can even arrange a
swap where no counter party is immediately available. Swaps are therefore tailored to customers' needs and are not
standardised in nature. Answers C and D were therefore not correct.
13. A company whose home currency is the dollar ($) expects to receive 500,000 pesos in 6 months' time from a
customer in a foreign country. The following interest rates and exchange rates are available to the company:
Working to the nearest $100, what is the six-month dollar value of the expected receipt using a money market
hedge?
A. $32,500
B. $33,700
C. $31,800
D. $31,900
LIBOR is currently at 1.0% and Snooper Ltd can borrow short-term debt at 3% above LIBOR.
A forward rate agreement is available for Snooper Ltd at 1.25%.
A. The appropriate type of forward rate agreement in this case would be a 3–9 FRA.
B. The FRA rate would be 5.25%.
C. If LIBOR was 0.75% on 31 March 2020, this would result in an obligation on Snooper Ltd to make an FRA
payment.
D. If LIBOR was 0.75% on 31 March 2020, the FRA payment or receipt would be $25,000.
When you calculate for the interest: don’t forget to prorate (if necessary) because the interest rate given is per annum.
15. Which of the following statements is/are true about Forward Rate Agreements?
A. 1 only
B. 2 only
C. Both 1 and 2
D. Neither
3-9 FRA: the borrowing will take place 3 months from now (NEW LOAN, not existing loan)
FRAs are used on planned loans, not existing ones, so statement 1 is wrong.
FRA are only available for large amounts. So, statement 2 is True.
Section B Trial exam JJ22 – Questions 16-30.
C14 & 15: Foreign currency risk & Interest rate risk
Case 1
Kerrin Co’s finance director is concerned about the effect of future interest rates on the company and has been looking at
the yield curve.
Kerrin Co, whose domestic currency is the dollar ($), plans to take out a $100m loan in three months’ time for a period of
nine months. The company is concerned that interest rates might rise before the loan is taken out and its bank has offered
a 3 v 12 forward rate agreement at 7.10 – 6.85.
The loan will be converted into pesos and invested in a nine-month project which is expected to generate income of 580m
pesos, with 200m pesos being paid in six months’ time (from today) and 380m pesos being paid in 12 months’ time (from
today). The current spot exchange rate is 5 pesos per $1.
As a result of the general uncertainty over interest rates, Kerrin Co is considering a variety of ways in which to manage its
interest rate risk, including the use of derivatives.
16. In relation to the yield curve, which of the following statements is correct?
A. A kink in the normal yield curve can be due to differing yields in different market segments.
B. Expectations theory suggests that deferred consumption requires increased compensation as maturity
increases.
C. Basis risk can cause the corporate yield curve to rise more steeply than the government yield curve.
D. An inverted yield curve can cause by government action to increase its long-term borrowing.
The term structure of interest rates suggests that the yield curve normally slopes upwards, so that debt with a longer term
to maturity has a higher yield than short-term debt.
Basis risk is nothing to do with the yield curve.
Occasionally, the yield curve can be inverted, indicating that the yield on short-term debt is higher than the yield on longer
term debt. One of the reasons why this can happen is because government policy has increased short-term interest rates
with the objective of reducing inflation, an action which falls in monetary policy.
17. If the interest rate on the loan is 6.5% when it is taken out, what is the nature of the compensatory payment under
the forward rate agreement?
A. $116.0m
B. $112.3m
C. $112.9m
D. $114,1m
19. In respect of Kerrin Co managing its interest rate risk, which of the following statements is/are correct?
(1) Smoothing is an interest rate risk hedging technique which involves maintaining a balance between assets
and liabilities.
(2) Matching is an interest rate risk hedging technique which involves maintaining a balance between fixed-rate
and floating-rate debt.
A. 1 only
B. 2 only
C. Both 1 and 2
D. Neither 1 nor 2
20. In relation to the use of derivatives by Kerrin Co, which of the following statements is correct?
A. An interest rate swap is an agreement to exchange both principal and interest rate payments
B. Kerrin Co can hedge interest rate on borrowing by selling a floor and buying a cap
C. Kerrin Co can hedge interest rate risk on borrowing by buying interest rate futures now and selling them back
in the future
D. Interest rate options must be exercised on their expiry date, if they have not been exercised before then.
C13: Business valuations
Case 2
Extract from the financial statements of Bluebell Co, a listed company, are as follows:
$m
Profit before interest and tax 238
Finance costs (24)
Profit before tax 214
Corporation tax (64)
Profit after tax 150
Assets
Non – current assets
Property, plant and equipment 768
Goodwill (internally generated) 105
873
Current assets
Inventories 285
Trade receivables 192
477
Total assets 1350
This competitor believes that if Bluebell Co were liquidated, property, plant and equipment would only realise $600m, while
10% of trade receivables would be irrecoverable and inventory would be sold at $30m less than its book value.
Separately, Bluebell Co is considering the acquisition of Dandelion Co, an unlisted company which is a supplier of Bluebell
Co.
A. $140.8m
B. $470.8m
C. $365.8m
D. $1,207.8m
Net realisable value = 1,350 – (768 - 600) – (192 x 0·1) – 30 – 105 – 662 = $365·8m
22. What is the value of Bluebell Co using the earnings yield method?
A. $2,675m
B. $1,200m
C. $1,875m
D. $2,975m
23. When valuing Bluebell Co using asset-based valuations, which of the following statements is correct?
The deprival value is what the company would lose if an asset wasn’t there, not the cost of replacing it.
Deprival value equals the lower of replacement cost and recoverable amount.
A. 1 only
B. 2 only
C. Both 1 and 2
D. Neither 1 nor 2
A. Dandelion Co is easier to value than Bluebell Co because a small number of shareholders own all the shares
B. Bluebell Co will have to pay a higher price per share to take control of Dandelion Co than if it were buying a
minority holding
C. Scrip dividends decrease the liquidity of shares by retaining cash in a company
D. Dandelion Co’s shares will trade at a premium to similar listed shares because it will have a lower cost of
equity
Case 3
Rose Co is a large company with an equity beta of 1.05 (geared company). The company plans to expand existing business
by acquiring a new factory at a cost of $20m. The finance for the expansion will be raised from an issue of 3% loan notes,
issued at nominal value of $100 per loan note. These loan notes will be redeemable after five years at nominal value or
convertible at that time into ordinary shares in Rose Co with a value expected to be $115 per loan note.
The risk-free rate of return is 2.5% and the equity risk premium is 7.8%.
Rose Co is seeking additional finance and is considering using Islamic finance and in particular would require a form which
would be similar to equity financing.
26. What is the cost of equity of Rose Co using the capital asset pricing model?
A. 13.3%
B. 10.7%
C. 8.1%
D. 10.3%
27. Using estimates of 5% and 6%, what is the cost of debt of the convertible loan notes?
A. 3.0%
B. 5.2%
C. 6.9%
D. 5.7%
28. In relation to using the dividend growth model to value Rose Co, which of the following statements is correct?
A. The model assumes that all shareholders of Rose Co have the same required rate of return
B. The model assumes a constant share price and a constant dividend growth for Rose Co
C. The model assumes that capital markets are semi-strong form efficient
D. The model assumes that Rose Co’s interim dividend is equal to the final dividend
29. Which of the following statements about equity finance is correct?
30. Regarding Rose Co’s interest in Islamic finance, which of the following statements is/are correct?
A. 1 only
B. 2 only
C. Both 1 and 2
D. Neither 1 nor 2
Murabaha is similar to trade credit and therefore would not meet Rose Co’s needs.
It is correct to state that Mudaraba involves an investing partner and a managing or working partner
Section C Trial exam JJ22 – Questions 31-32.
Notes:
1. The selling price per unit is $800 and a selling price increase of 5% will occur in February. Sales are all on one
month's credit.
2. Production of goods for sale takes place one month before sales.
3. Each unit produced requires two units of raw materials, costing $200 per unit. No raw materials inventory is held.
Raw material purchases are on one month's credit.
4. Variable overheads and wages equal to $100 per unit are incurred during production and paid in the month of
production.
5. The opening cash balance at 1 January is expected to be $40,000.
6. A long-term loan of $300,000 will be received at the beginning of March.
7. A machine costing $400,000 will be purchased for cash in March.
Required:
(a) Calculate the cash balance at the end of each month in the three-month period. (5marks)
(b) Calculate the forecast current ratio at the end of the three-month period. (2marks)
(c) Assuming that Corfe Co expects to have a short-term cash surplus during the three-month period, discuss whether
this should be invested in shares listed on a large stock market. (3marks)
(d) Explain how the Baumol model can be employed to reduce the costs of cash management. (5marks)
(e) Degnis Co, a subsidiary of Corfe Co, has set a minimum cash account balance of $7,500. The average cost to the
company of making deposits or selling investments is $18 per transaction and the standard deviation of its cash
flows was $1,000 per day during the last year. The average interest rate on investments is 5.11%.
Determine the spread, the upper limit and the return point for the cash account of Degnis Co using the Miller-Orr
model and explain the relevance of these values for the cash management of the company. (5marks)
(Total = 20 marks)
C11: The cost of capital
Question 32
A colleague has been taken ill. Our managing director has asked you to take over from the colleague and to provide
urgently needed estimates of the discounts rate to be used in appraising a large new investment. You have been given
your colleague’s working notes which believe to be numerically accurate.
Working notes:
The company’s gearing level (by market) is 1:2 debt to equity, and after-tax earnings available to ordinary shareholders in
the most recent year were $5,400,000 of which $2,140,000 was distributed as ordinary dividends. The company has 10
million issued ordinary shares, which are currently trading on the Stock Exchange at 321 cents. Corporate debt may be
assumed to be risk-free. The company pays tax at 35% and personal taxation may be ignored.
Required:
Under what circumstances would these models be expected to produce similar values for the weighted average cost
of capital.
(9 marks)
(b) You are now informed that the proposed investment is a major diversification into a new industry, and are provided
with the following information about the new industry:
Average industry gearing level (by market value) 1:3 debt to equity
Average β equity 1:50
Using any relevant information from parts (a) and (b), recommend which cost of equity should be used for the
investment. Any relevant calculations not included in your answer to part (a) should form part of your answer.
(6 marks)
(c) Discuss the problems estimating the appropriate data inputs for using the capital assets pricing model in investment
appraisal.
(5 marks)
(Total=20 marks)