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Mock

1 financial strategy focuses on financial objectives. Which of the following are financial
objectives?

1. Maximisation of market share


2. Earnings growth
3. Sales revenue growth
4. Achieving a target level of customer satisfaction
5. Achieving a target level of return on capital employed

1 and 5 only.

2 and 4 only.

2, 3 and 5 only.

1, 2, 3 and 4 only.

Ans The answer is C.

Achieving market share (a relative measure) and customer satisfaction (a qualitative measure) are non-financial
objectives.

2 Hales Co has a stated financial objective to pay out 50% of its profit after tax as a dividend. It
is a geared company, with 1 million $1 shares in issue, and a $5 million bank borrowing with a
fixed interest rate of 8% per year.

Last year, the company made a profit before interest and tax of $22 million. The expectation is
that this year’s profit before interest and tax will be 10% higher.

The tax rate is 20%.

What dividend will Hales Co pay out this year, assuming that all expectations and
objectives are met?
$9.52 million

$9.68 million

$12.10 million
$19.04 million

Ans Profit before interest and tax will rise to $24.2 million this year if expectations are met ($22 million × 1.10).

Interest charge will be $5 million × 8% = $0.4 million, so profit after tax will be:

($24.2 million - $0.4 million) × (1-0.20) = $19.04 million.

Dividend paid will be 50% of this, so $9.52 million.

3 Which of the following is an example of a financial objective that a company might


choose to pursue?

Dealing honestly and fairly with customers on all occasions.

Provision of good working conditions and industrial relations.

Producing environmentally friendly products.

Restricting the level of gearing to below a specified target level.


Ans he answer is D.

This is a financial objective that relates to the level of financial risk that the company is prepared to accept. The other
objectives are non-financial.

4 Bell Co has borrowed $12 million from its bank, at an interest rate of 10%. The bank insisted
on a debt covenant limit of 3 times for interest cover.

Bell Co is just finalising its annual accounts. Profit before interest and tax is $5 million and the
tax rate is 25%.

Which THREE of the following statements are correct?

Interest cover is 4.17.

Interest cover is 2.38.

The covenant has been breached.

The covenant has not been breached.


The tax charge is $0.95 million.
Ans he statement of profit and loss will be:

$m
PBIT 5
Interest (10% × $12m) (1.2)
PBT 3.8
Tax (25%) (0.95)
PAT 2.85

So clearly the tax charge is $0.95 million.

Interest cover is PBIT / Interest = 5/1.2 = 4.17

This is higher than the covenant limit of 3, so the covenant has not been breached.

5 Woakes Co is a geared company. Its capital structure today, on the last day of the financial
year, is:

Book value Market value


($ million) ($ million)
Equity ($1 shares) 25.0 33.5
Debt ($100, 7% coupon bonds) 15.0 16.5

Woakes Co intends to pay a dividend shortly after the year end to ensure that the
shareholders’ dividend yield will be 15%. The interest on the bonds is also due just after the
year end. The tax rate is 30%.

What will be the total payment of interest and dividends just after the year end?

$4.485 million

$4.800 million

$5.760 million

$6.075 million
Ans The total payment of interest and dividends just after the year end is calculated as:
Dividend yield = Dividend / MV equity = 15%

With a MV of equity of $33.5 million, dividend will be $5.025 million

Interest (paid on nominal value) = 7% × $15 million = $1.05 million.

Total distribution = $6.075 million

6 Which of the following is an ‘efficiency’ target that a not for profit organisation might
put in place?
Negotiation of bulk discounts.

Pay rates for staff of appropriate levels of qualification.

Staff utilisation.

Customer satisfaction ratings.

Ans The answer is C.

Negotiation of bulk discounts is an ‘economy target’ (A). Paying rates for staff of appropriate levels of qualification is
also an ‘economy’ target (B). Customer satisfaction rating is an ‘effectiveness’ target (D).

7 Morgan Co has a P/E ratio of 8 and a dividend yield of 10%.

What is the company’s dividend cover?

0.125

0.8

1.25

80

Ans P/E is Share price / Profit after tax (PAT)

Dividend yield is Dividend / Share price

Dividend cover is PAT / Dividend = (Share price / 8) / (Share price × 10%) = 1.25
8 The current spot exchange rate between GBP and EUR is GBP / EUR 1.4415 (that is EUR
1.4415 to GBP 1). The GBP three month interest rate is 5.75% pa and the EUR three month
interest rate is 4.75% pa.

What should the three month GBP / EUR forward rate be? (GBP / EUR …)
1.4553

1.4379

1.4279

1.4451

The answer is B.

Applying interest rate parity:

Invest GBP1,000 at 5.75% for three months (0.0575/4) = GBP1,014.375

Convert GBP1,000 to EUR at 1.4415 = EUR1,441.5

Invest that at 4.75% for three months (0.0475/4) = EUR1,458.62

Implied forward rate is therefore 1,458.62/1,014.375 = 1.4379

Distractors – not converting the annual rate to the three monthly one:

GBP1,000 becoming GBP1,057.50

EUR1,441.50 becoming EUR1,509.97

Forward rate = 1.4279

Applying wrong interest rates (GBP/EUR mixed up):

1,000 × (1 + 0.0475/4) = 1,011.88

1,441.50 × (1 + 0.0575/4) = 1,462.22

Forward rate = 1.4451

1,000 × 1.0475 = 1,047.5

1,441.50 × 1.0575 = 1,524.39

Forward rate = 1.4553


9 Which of the following bodies produced the ‘Sustainability Reporting Guidelines’,
which propose additional disclosures, in addition to the standard disclosures required in
the financial statements?
The International Integrated Reporting Council (IIRC).

The International Accounting Standards Board (IASB).

The Global Reporting Initiative (GRI).

The London Stock Exchange.

Ans The answer is C.

The latest version of the guidelines (‘G4’) was published in May 2013.

10 Which THREE of the following are considered to be limitations of using financial


statements to assess the performance of incorporated entities?
Financial statements of incorporated entities have to be audited.

Financial statements do not give information regarding changes in senior management.

Financial statements do not give information about the competitive environment in which
the entity operates.
Financial statements contain detailed financial information.

Financial statements only disclose information regarding the historic performance of the
entity.
Ans The fact that financial statements have to be audited (A) and contain detailed financial information (D) are
positive factors, not limitations.

11 Blood Co's directors are preparing an integrated report for the first time. They are
following the guidelines as proposed by the International Integrated Reporting
Council's Integrated Reporting (<IR>) Framework.

According to the <IR> Framework, Blood Co should disclose its 'capitals' under the
headings of financial, manufactured, intellectual, human, social and relationship, and
natural capitals.

Drag and drop the following capitals of Blood Co to the correct heading in the
integrated report.

Financial
__________________________________________
Manufactured
__________________________________________
Intellectual
__________________________________________

Social/relationship
__________________________________________

Blood Co’s factory


The Blood Co brand logo
Patent for a new product
Cash in the bank

12 Clood Co has been allocated an AAA credit rating by a large credit rating agency, while
Grunge Co is A rated.

Which of the following statements is NOT correct?


Grunge Co will have a lower cost of borrowing than Clood Co.

Both Grunge Co and Clood Co are assessed as having a strong capacity to meet their
financial commitments.
The credit rating agency believes that Clood Co is more creditworthy than Grunge Co.

Grunge Co’s lenders will expect a higher rate of return than Clood Co’s lenders.
Ans

The answer is A.

The company with the better credit rating will have the lower cost of borrowing (and rate of return to lenders).

Both companies are highly rated, so both are assessed as having a strong capacity to meet their financial
commitments (B). However, Clood Co’s AAA rating suggests that the credit rating agency believes that Clood Co is
more creditworthy than Grunge Co (C).

13 Vole Bank has just received a loan application from a rapidly growing IT consultancy
company.

In assessing the creditworthiness of the prospective client, which of the following


pieces of information is LEAST likely to be important to Vole Bank?

Cash forecasts showing expected future growth.


Information regarding the prospective client’s competitive position within the market place.

Detailed analysis of the prospective client’s management team, their qualifications and
experience.
Financial statements for the last three years.
Ans
The answer is D.

The bank will want to assess the future prospects of the client, by looking at cash flow forecasts (A),
competitive position (B) and details of the management team(C). Historic information (D) will not necessarily
be indicative of future performance in this rapidly growing company.

14 Winter Co is preparing its financial statements. In order to comply with IFRS 7: Financial
Instruments – Disclosures, the directors know that they have to provide information under the
three headings of credit risk, market risk and liquidity risk.

Match the following disclosures of Winter Co to the correct heading.

Credit
risk
_______________________________________________________________
___________
Market
risk
_______________________________________________________________
___________
Liquidi
ty risk
_______________________________________________________________
___________

A borrowing from Summer Bank repayable in three years.


The impact of a 5% weakening of Winter Co’s functional currency on its sales revenue.
An investment in CDs (certificates of deposit).

Ans Credit risk = an investment in CDs

Market risk = weakening of the currency which affects turnover

Liquidity = borrowing repayable in 3 years


15 Ryan Co is a UK based company, whose functional currency is the British Pound (GBP). It
has a highly probable receipt of USD 20,000 due in June 20X6, so on 1 January 20X6 it enters
into a forward contract for nil cost to hedge this receipt. The forward is documented and
designated as a cash flow hedge when entered in to.

The reporting date of the company is 31 March 20X6.

In June of 20X6, Ryan Co makes the sale of USD 20,000 and collects the cash before the end
of June 20X6. The relevant exchange rates are as follows:

1 January 20X6 (and contract rate) GBP / USD 1.35


(that is GBP 1 = USD 1.35)
31 March 20X6 GBP / USD 1.42
June 20X6 GBP / USD 1.55

The cash flow hedge has been assessed as being 100% effective throughout the hedging
period.

What accounting entry will record the movement in the value of the forward contract at
31 March 20X6?
GBP 730 recorded in Other Comprehensive Income.

GBP 730 recorded in the Statement of Profit or Loss.

GBP 1,911 recorded in Other Comprehensive Income.

No entry should be made, because the cash has not yet been received.

Ans The answer is A.

The forward, being a derivative, will be remeasured at fair value on an ongoing basis with the movement on the
effective portion going to Other Comprehensive Income (OCI) until the hedged item is recognised. At the year end the
forward would have a value of:

((USD 20,000/1.35)-(USD 20,000/1.42)) GBP 730.

As the hedge is 100% effective, this would be taken in full to OCI.

Note for tutorial purposes:

In June 20X6 the value of the forward will remeasured by adding

((USD 20,000/1.42)-(USD 20,000/1.55)) GBP 1,181.

Therefore, the total taken to OCI which is then recycled to profit or loss is.

(GBP 730+ GBP 1,181) GBP 1,911


16 Which THREE of the following are advantages of a stock market listing?

More accessible employee share schemes.

Easier to organise rights issues.

Raised profile of the entity.

Fewer regulatory requirements.

Easier to value the entity.


Ans A listing increases the regulatory burden for an entity. Also, with a much wider pool of shareholders, rights issues
become more difficult to organise after a listing.

17 Which of the following statements is part of the traditional theory of gearing?

There must be taxes.

There must exist a minimum WACC.

Cost of debt increases as gearing decreases.

Cost of equity increases as gearing decreases.


Ans The answer is B.

The traditional view is that as an organisation introduces debt into its capital structure, the weighted average cost of
capital will fall. This is because, initially, the benefit of cheap debt finance more than outweighs any increases in the
cost of equity required to compensate equity holders for higher financial risk. As gearing continues to increase, equity
holders will ask for progressively higher returns and eventually this increase will start to outweigh the benefit of cheap
debt finance, and the weighted average cost of capital will rise.

18 Compared to ordinary secured loan notes, what are convertible secured loan notes
likely to be?

More expensive to service because of their equity component.

Less expensive to service because of their equity component.

More expensive to service because converting to equity requires the holders to make
additional payments.
Less expensive to service because they must rank after ordinary secured loan stock.
Ans he answer is B.

Because of the potential for making gains by conversion, investors are willing to accept a lower coupon rate on the
debt

 The equity component is not a risk imposed on holders.

 Convertibles keep holders’ options open.

 Additional payments are not required.

 They don’t have to rank after ordinary debt and even if they did, this would increase their
servicing cost.

19 Compton has announced a 1 for 4 rights issue at a subscription price of $2.50. The current
cum-rights price of the shares is $4.10.

What is the theoretical ex-rights price of the shares?

$3.78

$2.82

$3.55

$1.32

Ans The answer is A.

TERP = (4 x $4.10 + $2.50) / 5 = $3.78

20 Which THREE of the following factors would be likely to encourage an entity to raise
equity in preference to debt finance to fund a new investment project?

The cash flows from the project are volatile.

The gearing is already above the industry norm.

The business has good quality tangible assets.


Banks are willing to lend.

Current shareholders are willing to invest more in the business.


Ans Good quality tangible assets (C) and banks keen to lend (D) would be important factors if debt finance were to
be raised.

21 Grange Co is going for a stock market listing by issuing shares by tender. Analysts' research
has revealed the following information:

If a share price of $2.70 is set, it is likely that 100 million shares will sell. If a price of $2.50 is
set, it is likely that 200 million more shares will sell. However, if the share price is set at $2.20,
then a further 350 million will sell.

What subscription price should be set, and how much cash will be raised in total,
assuming that Grange Co sets the subscription price to raise the maximum amount of
cash?

Subscription price Total cash raised


A $2.20 $1,540 million
B $2.20 $1,430 million
C $2.50 $770 million
D $2.70 $270 million
A

Ans The answer is B.

Set the subscription price at $2.20, and all the investors who would be willing to buy at $2.70 and $2.50 will also buy
at $2.20. So the maximum amount will be raised by selling 650m at $2.20 per share i.e. $1,430 million raised in total.

22 The following statements are about capital structure theory. Which one is correct?
In the traditional view, there is a linear relationship between the cost of equity and financial
risk.
Modigliani and Miller said that, in the absence of tax, the cost of equity would remain
constant.
Modigliani and Miller’s with tax theory is based on real world observation.

Business risk is assumed to be constant.


The answer is D.
23 Cruel Co is currently paying interest on its $1 million borrowing at a fixed rate of 4.50%. The
directors are concerned that interest rates are going to fall over the next year, so they have
approached their bank to discuss the possibility of setting up a one year interest rate swap.

The bank is currently quoting one year swap rates of 4.30 (bid) and 4.35 (ask).

Assuming that floating interest rates are quoted as a margin against LIBOR, what will be
Cruel Co’s interest rate over the next year if it enters into an interest rate swap with its
bank?

4.30%

4.35%

LIBOR + 0.20%

LIBOR + 0.15%

Ans The answer is C.

Cruel Co is currently paying 4.50%, but if it pays LIBOR to the bank, the bank will return 4.30%. Hence, the
net rate is 4.50% + LIBOR - 4.30% = LIBOR + 0.20%.

24 Which of the following statements correctly describes the process of making a public
issue of bonds on the London Stock Exchange?

Apply (to the UK Listing Authority) to become listed; satisfy the stock exchange’s
admission and disclosure standards; then appoint a registered market maker to promote
the sale of the bonds.
Apply (to the UK Government) to become listed; then appoint a registered market maker
to promote the sale of the bonds.
Prepare a prospectus and appoint an adviser who can send the prospectus to its clients,
to encourage the clients to purchase the new bonds.
Apply (to the UK Listing Authority) to become listed; satisfy the stock exchange’s
admission and disclosure standards; then ask prospective investors to tender for the
bonds.

Ans the answer is A.

25 Pusher Co is planning to either buy a new machine outright or to lease it under an


operating lease agreement.
Details of the purchase:
 Pusher Co would buy the new machine on 1 January 20X3, financed by a 6% bank
borrowing.
 Maintenance costs are expected to be of the order of $1.5 million per year if Pusher Co
purchases the machine outright.

Details of the operating lease agreement:

 An initial up-front payment of $5.8 million would be payable at the start of the lease on 1
January 20X3, then ten further lease payments of $5.8 million each would be payable
on 31 December in each year starting on 31 December 20X3.
 The lessor retains responsibility for maintaining the machine throughout the period of
the lease.

Additional information:

 Pusher Co’s financial year runs from 1 January to 31 December.


 Pusher Co pays corporate income tax at a rate of 33%, payable annually at the end of
the year following that in which the tax charge or tax saving arises.

The assistant to the finance director has prepared the following calculations to show the impact
of the operating lease.

Narrative $ million Timing DF at 6% PV


Initial payment (5.8) T0 1 (5.8)
Tax relief on initial payment 1.9 T1 0.943 1.8
Lease payments (5.8) T1-T10 7.36 (42.7)
Tax relief on lease payments 1.9 T2-T11 6.94 13.2
--------- ---------
NPV (33.5)
--------- ---------

Which TWO of the cells in this table contain errors?

T1

T1-T10

DF at 6%

7.36
Ans The two cells containing the errors are highlighted below:

Narrative $ million Timing DF at 6% PV


Initial payment (5.8) T0 1 (5.8)
Tax relief on initial payment 1.9 T1 0.943 1.8
Lease payments (5.8) T1-T10 7.36 (42.7)
Tax relief on lease payments 1.9 T2-T11 6.94 13.2
--------- ---------
NPV (33.5)
--------- ---------

Explanations:

1. If the first payment is on 1 January 20X3, the tax impact will be felt one year after the end of the year 20X3,
i.e. in 2 years’ time on 31 December 20X4.
2. The discount rate in a lease v buy evaluation should be the POST-TAX cost of debt, i.e. 6% × (1-0.33) = 4%.

26 GG has a large amount of cash in its statement of financial position, so the directors are
trying to decide whether to use $200,000 to pay a one-off dividend or to repurchase some of
the company’s shares at market value.

There are 100,000 $1 shares in issue, trading at $20.

The assistant to the finance director has prepared the following calculations to show the impact
of the one-off dividend and the share repurchase on a shareholder who owns 1,000 shares.

Impact of dividend on shareholder wealth:

Wealth after
(1,000 × $20) + (1,000 × $2) = $22,000
dividend paid =
No of Amount
Share Dividends
shares received per
price received
owned share

Impact of share repurchase on shareholder wealth:

Wealth after
(900 × $22.22) + (100 × $20) = $22,000
repurchase =
No of Amount
Share Shares
shares received per
price sold
owned share
Which TWO of the figures above are incorrect?

Impact of dividend: $20

Impact of dividend: $2

Impact of share purchase: $22.22

Impact of share purchase: $20


Ans The two cells containing the errors are highlighted below:

Impact of dividend on shareholder wealth:

Wealth after dividend


(1,000 × $20) + (1,000 × $2) = $22,000
paid =
No of shares Share Dividends Amount received per
owned price received share

Impact of share repurchase on shareholder wealth:

Wealth after repurchase


(900 × $22.22) + (100 × $20) = $22,000
=
No of shares Share Shares Amount received per
owned price sold share

Explanations:

1. If a $200,000 dividend is paid out to 100,000 shareholders, the dividend will be $2 per share. Therefore, the
ex-dividend value of the share will be $20 - $2 = $18, not $20 as stated here.
2. Using $200,000 to repurchase shares at $20 each means that 10,000 shares (200,000 / 20) will be
repurchased – 10% of the total. Therefore, the share price after the repurchase will be [($20 x 100,000) -
$200,000] / (100,000 – 10,000) = $20, not $22.22 as stated here.

The total wealth in each case will be $20,000, not $22,000 as shown here.

27 What is the impact of a scrip dividend: on the wealth of an entity’s shareholders and
on its gearing ratio (measured as debt / equity, valued at market value)?

Shareholder wealth Gearing ratio


A Unchanged Unchanged
B Unchanged Decrease
C Increase Unchanged
D Increase Decrease
A

Ans The answer is A.

The scrip dividend increases the number of shares, but the share price falls to leave shareholder wealth unchanged.
Therefore, the gearing ratio is also unchanged.

28 ABC is a successful, rapidly growing company. Its total earnings and dividends over the last
five years have been:

Last year 2 years ago 3 years ago 4 years ago 5 years ago
Dividends ($m) 5.4 1.8 Zero 2.5 2.2
Earnings ($m) 12.4 10.1 8.6 7.3 6.8

ABC’s directors have always tried to follow the dividend irrelevancy theory as proposed by
Modigliani and Miller when setting their company’s dividend policy.

What is the most likely explanation for the zero dividend three years ago?

ABC was following a zero dividend policy.

ABC had insufficient distributable profits to enable it to maintain its dividend level.

ABC decided to use the cash to fund a positive NPV project.

ABC wanted to attract a different clientele of shareholders.

Ans The answer is A.

The scrip dividend increases the number of shares, but the share price falls to leave shareholder wealth unchanged.
Therefore, the gearing ratio is also unchanged.
29 Adams Co has made a healthy profit in the most recent financial year, and has always paid
an annual dividend in the past.

However, Adams Co’s directors have decided that the company cannot afford to pay a dividend
this year, because they are keen to undertake an expensive new investment project with a
positive NPV.

Rather than just waiving the dividend, the directors are considering declaring a scrip dividend
instead.

Which of the following statements is INCORRECT?

A scrip dividend results in a greater number of shares in circulation and increased


pressure for dividend pay-outs in the future (if the company wants to maintain dividend
per share).
A scrip dividend has the effect of moving reserves from distributable to non-distributable
by increasing share capital. This reduces the reserves available for distribution as
dividends at a future date.
A scrip dividend has the effect of reducing shareholder wealth, whereas a dividend waiver
causes share price to rise and, therefore, shareholder wealth to increase.
Both a scrip dividend and a dividend waiver will enable the company to retain cash within
the business to reinvest in the new project.
Ans The answer is C.

In both situations (scrip dividend and dividend waiver), the shareholder wealth will be unchanged initially, until the
positive NPV project is undertaken, at which point shareholder will increase to reflect the project’s positive NPV.

30 QPR is a successful, listed company. Its earnings per share (EPS), dividends per share
(DPS) and share prices over the last three years have been as follows:

Last year 2 years ago 3 years ago


DPS ($) 0.18 0.15 0.12
EPS ($) 0.44 0.42 0.38
Share price ($) 4.12 3.87 3.77

What has been the highest value of QPR’s dividend yield over the last three years?
3.2%
4.4%

9.9%

40.9%

Ans he answer is B.

Dividend yield is (dividend / share price) which was highest last year, at 4.4% (0.18 / 4.12)

31 Alpha Co is an all equity financed company. It has a cost of equity of 8%.

The directors are considering changing the company’s capital structure, so that the gearing ratio
is 25% (measured as debt value / (debt value + equity value)).

The yield on the new debt finance raised will be 5% and the corporate tax rate is 30%.

What will be the cost of equity of Alpha Co after the debt issue?
5.0%

8.0%

8.5%

8.7%

Ans The answer is D.

Using M+M’s formula:

Cost of equity in the geared company = 8% + [(8% - 5%) (25/75) (1-0.30)] = 8.7%

32 Gamma Co is an unlisted, ungeared company whose cost of equity is 12.50%. The directors
are considering raising some debt finance, and expect to achieve a gearing ratio of 25%
(measured as (debt/(debt + equity)) immediately after the debt issue. The debt issued will carry
a coupon rate of 3.00%, but the yield to investors will be 4.00%.

The corporate tax rate is 20%.

Gamma Co’s directors have prepared the following calculation of their company’s likely cost of
equity.
What error have the directors made in their calculation?
Modigliani and Miller’s formula should not have been used, given that Gamma Co is an
unlisted company.
Incorrect figure used for kd (the return to lenders).

Incorrect gearing ratio used.

The answer of 14.20% does not follow mathematically from the workings presented.

Ans The answer is C.

The gearing ratio is 25% measured as (debt/(debt+equity)) but in the M+M formula, the gearing ratio should be
(debt/equity). Therefore, (25/75) should have been used in the formula, not (25/100).

33 Delta Co is an ungeared company, with 1 million shares in issue trading at $1.50 per share.
The directors are planning to repurchase one quarter of the shares at their current market value,
by issuing a 6% coupon corporate bond.

The corporate tax rate is 20%.

What will be the share price of Delta Co after the bond issue and share repurchase (to the
nearest $0.01)?
$1.50

$1.60

$1.58

$1.13

Ans The answer is B.

Modigliani and Miller’s formula states:

Value of a geared company = value of the ungeared company + (tax rate x debt value).

Therefore, the value of Delta Co after the debt is issued will be:

(1m x $1.50) + [20% x (0.25 x $1.5m)] = $1.575 million

Since the debt value will be (1/4 of $1.5m) $375,000, this leaves an equity value of $1.2 million.

Since one quarter of the shares was repurchased, three quarters (750,000) will remain in issue, so the share price
will be:

$1.2m / 750,000 = $1.60.


34 Teclo Co, a highly geared company, needs cash to fund some profitable new investment
projects. It is considering cutting the upcoming dividend payment to zero, to enable the new
investments to be made.

However, the company’s financial advisers have warned that the cut in dividend might send a
negative signal to the market, and that the company’s clientele of shareholders may be very
unhappy if they don’t receive their upcoming dividends.

Which THREE of the following strategies would be most appropriate in this situation?
Cut the dividend to zero despite the advisers’ warnings, on the basis that dividend
irrelevancy theory suggests that it shouldn’t matter to shareholders whether dividends are
paid out this year or not.
Leave the dividend unchanged and use a bond issue to fund the new investments.

Sell some of the company’s non-current assets under a sale and leaseback scheme.

Hold an extraordinary general meeting of shareholders and fully explain the reasons for the
potential cut in dividends to minimize the impact of the signal.
Leave the dividend unchanged and issue some new shares, either through a rights issue
or a placing, to raise funds for the new investment projects.

Ans n theory, dividend irrelevancy theory suggests that shareholders should be indifferent between dividends and
capital gains (A), but we are told in this real-world case that the clientele of shareholders have a preference for
dividends. Any cut in dividend will have to be well explained (D) to minimise the impact.

A new issue of equity (E) or bonds (B) would raise the necessary finance, but this company is highly geared already
so a bond issue would probably be unwise.

A sale and leaseback (C) could certainly be used to raise cash now to fund the new projects.

35 Harry Co has 10 million shares in issue, trading at $4.50. It is about to undertake a rights
issue, where new shares will be issued at a 20% discount to current share price, in order to
raise $10 million to invest in a new project with an NPV of $7 million.

What is the theoretical ex-rights price of the Harry Co shares, assuming that the market
is fully informed about the project?

$4.50

$4.85

$4.30
$5.07
Ans The answer is B.

The number of shares issued will be 10 million / (80% x 4.50) = 2,777,778.

Therefore, TERP = [($4.50 x 10m) + $10m + $7m] / (10m + 2,777,778 = $4.85

36 Cool Co is a small, unlisted company. The company’s founding family own 60% of the equity
and the other shares are owned by a private equity company and two business angels. Cool Co
has paid a steadily increasing dividend over the last three years and both family and non-family
shareholders have expressed their satisfaction with this policy.

The directors of Cool Co want to expand the business by investing in a new project. The
company has insufficient cash available to fund the new project, but coincidentally the amount
of cash needed is approximately equal to the value of the upcoming dividend. Consequently, the
directors are considering offering a scrip dividend instead of a cash dividend so that the
company can use the cash for investment.

Which THREE of the following are problems with offering a scrip dividend in these
circumstances?
A scrip dividend requires some cash to be paid out, albeit less cash than with a cash
dividend, so the company would not be able to afford to invest in the project if it were to
offer a scrip dividend to shareholders.
The clientele effect suggests that the non-family shareholders would be dissatisfied if a
scrip dividend were offered.
A scrip dividend would give a negative signal to the market, so would adversely affect Cool
Co’s share price.
A scrip dividend would result in more shares being in issue, so would increase the
necessary dividend payments in future years.
The bird-in-the-hand argument suggests that the family shareholders would prefer a cash
dividend.

Ans A scrip dividend does not require any cash to be paid out (A) and an unlisted company doesn’t have a market
share price (C) so the signalling effect is irrelevant.

37 Mr Mays has been left $30,000 which he plans to invest on the Stock Exchange in order to
have a source of capital should be decide to start his own business in a few years’ time. A friend
of his works in the City of London and has told him that the London Stock Exchange shows
strong form market efficiency.

If this is the case, which of the following investment strategies should Mr Mays follow?
Study the company reports in the press and try to spot under-valued shares in which to
invest.
Invest in two or three blue chip companies and hold the shares for as long as possible.

Build up a good spread of shares in different industry sectors.

Study the company reports in the press and try to spot strongly growing companies in
which to invest.

Ans The answer is C.

The preferred approach is a good spread of shares, as this minimises the risk in the portfolio and should ensure Mr
Mays does achieve something approaching the average return for the market. Strong form efficiency means that Mr
Mays cannot do anything to guarantee beating the market – even by insider trading, so options A and D are a waste
of time.

38 The shares of Fortunate are currently valued on a P/E ratio of 8. The company is
considering a takeover bid for Seed, but the shareholders of Seed have indicated that they
would not accept an offer unless it values their shares on a P/E multiple of at least 10.

Which of the following is not a reason which might justify an offer by Fortunate for the
shares of Seed on a higher P/E multiple?

Seed has better growth prospects than Fortunate.

Seed has better-quality assets than Fortunate.

Seed has a higher gearing ratio than Fortunate.

Seed is in a different country from Fortunate, where average P/E ratios are higher.
Ans The answer is C.

A higher P/E ratio valuation may be justified when the target company has higher growth prospects, or when it is in
an industry where the normal P/E ratio is higher than in the industry of the bidder. Better-quality assets might also be
a reason for offering a price that values the target on a higher P/E. Higher gearing ratios are more likely to reduce the
P/E ratio than increase it.

39 Peter Co has made an offer of one of its shares for every three of Baker Co. Synergistic
benefits from the merger would result in an increase in after-tax earnings of $4m per annum.
Extracts from the latest accounts of both companies are as follows:

Peter Co Baker Co
Profit after tax $120m $35m
Number of shares 400 million 90 million
Market price of shares 250c 120c
Assume that the price of Peter Co's shares rises by 50c after the merger and that Peter issues
new shares as consideration.

What is the implied price-earnings ratio of the group?


6.76

8.11

9.07

10.75

Ans he answer is B.

Number of shares in issue = 400m + 30m = 430m

Earnings = $(120m + 35m + 4m)= $159m

EPS = $159m/430m= $0.370

Price per share = $3.00

P/E ratio = 3.0/0.370 = 8.11

40 For a company, let

EPS = Earnings per share

PPS = Price per share

VPS = Value per share

EY = Earnings yield

TE = Total earnings

Which one of the following is the best expression for the value of the company?
TE x [1 / EY]

EPS x [1 / EY]

EPS / PPS

PPS / EPS
The answer is A.

Answer B = Value per share

Answer C = Earnings yield

Answer D = Price earnings ratio

41 The managers in Chapelle Co wish to buy the company from its parent company. The parent
company has indicated that this is a possibility as it feels Chapelle no longer fits with its core
strategy. They have indicated that a price of $20.0 million would be acceptable.

The managers can raise $7.0 million collectively and a bank has indicated a willingness to lend
$4.0 million (secured on all the entity's physical assets). The managers have approached a
venture capital company to provide the balance in a mix of debt and equity.

What is the most likely value of the equity funding to be provided by the venture
capitalist?
$8.5 million

$6.5 million

$0.5 million

$9.0 million

Ans The answer is B.

This will ensure that the managers have just greater than 50% of the total equity. Therefore, they will collectively have
overall control.

42 Company A is in the process of buying Company B. The directors of A believe that the
market will perceive the new combined entity to have the same growth prospects as A currently
has as an individual entity.

A has recently reported EPS of $0.50 and its current share price is $5.00. It has 1 million shares
in issue.

B has recently reported EPS of $0.70 and its current share price is $2.80. It has 0.5 million
shares in issue.

The expected synergies are likely to produce post-tax earnings of $100,000 per annum.

B has accepted a share for share exchange, the terms of which are 3 new shares in the
combined entity for every 4 currently held.

What is the likely post-acquisition share price for the combined company?
$5.18

$5.00

$6.91

$6.33

Ans The answer is C.

Workings:

First calculate the value of the combined entity:

A earnings = $0.50 x 1m = $0.5m

B earnings $0.70 x 0.5m = $0.35m

Synergies = $0.1m

Expected PAT of the combined entity = $0.95m

Using A's P/E ratio (since the market expects the same growth in the combined entity as for A alone), which is
$5/$0.50 = 10

Value of combined entity = $0.95m x 10 = $9.5m

Issuing 3 new shares for every 4 currently held will result in 0.375m new shares issued (3/4 x 0.5m)

So total number of post-acquisition shares will be 1m plus 0.375m = 1.375m.

Likely post-acquisition share price = $9.5m / 1.375m = $6.91

43 SKV Co has paid the following dividends per share in recent years:

Year 20X3 20X2 20X1 20X0


Dividend (cents per share) 36.0 33.8 32.8 31.1

The dividend for 20X3 has just been paid and SKV Co has a cost of equity of 12%.

Using the average historical dividend growth rate and the dividend growth model, what is
the market price of SKV Co shares to the nearest cent on an ex dividend basis?
$4.67

$5.14

$5.40

$6.97

Ans The answer is C.

The average dividend growth rate is (36.0/31.1)1/3 – 1 = 5%

The ex div share price = (36.0 x 1.05)/(0.12 – 0.05) = $5.40

44 Gurdip plots the historic movements of share prices and uses this analysis to make her
investment decisions.

To what extent does Gurdip believe capital markets to be efficient?


Not efficient at all.

Weak form efficient.

Semi-strong form efficient.

Strong form efficient.

Ans The answer is A.

If the market were even weakly efficient, such information would already be reflected in the share price.

45 Which ONE of the following CORRECTLY labels the lines on the following graph?
1 = Total risk, 2 = Unsystematic risk, 3 = Systematic risk

1 = Unsystematic risk, 2 = Systematic risk, 3 = Total risk

1 = Unsystematic risk, 2 = Total risk, 3 = Systematic risk

1 = Total risk, 2 = Systematic risk, 3 = Unsystematic risk


Ans The answer is C.

46 Abbott Co is a large supermarket company. Its directors are planning to acquire Heat Co, a
smaller competitor in the same industry.

It hopes to increase shareholder wealth by generating large synergies, particularly in staff costs
and interest payments to its lenders (due to an improvement in its credit rating).

Which of the following issues is likely to be of MOST concern to the competition


authorities?
Many of the Heat Co employees may be made redundant.

The lenders to Abbott Co will not necessarily assign a better credit rating to the company.

The combined company might put prices up in an attempt to increase shareholder wealth.

The Heat Co shareholders might not be offered a sufficiently high premium on the
acquisition, given the size of synergies expected.

Ans The answer is C.

The competition authorities will only be concerned about those factors that will affect the degree of competition in the
market place.

47 AS Co is a large, all-equity financed company that manufactures mechanical parts for


bicycles. It intends to acquire BG Co, a smaller, all-equity financed company in the same
industrial sector.

The takeover consideration is to be cash, funded by borrowings.

Which THREE of the following factors are likely to arise as a consequence of the
acquisition?
The combined company is likely to have greater bargaining power over its suppliers.

AS Co’s cost of equity is likely to rise.

AS Co’s weighted average cost of capital is likely to rise.

Synergies are likely to be generated by combining the operations of the two companies.
AS Co’s equity beta is likely to fall.

Ans The companies operate in the same industrial sector, so market power and operating synergies - (B) and (D) -
are likely to arise. An increase in gearing will cause financial risk to increase and hence cost of equity to increase (A).

However, the WACC of AS Co will fall and the equity beta will rise due to the constant business risk but increasing
financial risk.

48 Pook Co was set up 3 years ago. It has made losses in the first three years of trading, but
the directors are confident that it will report a profit for the first time in the near future, and will
then be able to afford to start paying a dividend.

It operates in a high technology sector, in an industry where staff knowledge and expertise is a
core competence.

Which of the following business valuation methods would be most appropriate if trying
to value the equity of Pook Co?
The price/earnings method.

The dividend valuation model.

The net assets method.

The calculated intangible value method.

Ans The answer is D.

No profits or dividends to date would make forecasting profits and/or dividends very difficult. The company relies
heavily on the intellectual capital of its staff expertise (rather than its tangible assets), so the calculated intangible
value method would seem to be most appropriate.

49 Queen Co is intending to acquire an owner-managed business King Co using an earnout


method.

Which THREE of the following are advantages to Queen Co of using an earnout rather
than a cash purchase?

There is less of a financing issue, because some of the purchase consideration can be
deferred.
The owners of King Co are bought out, so play no further role in the combined business.

The transition from one ownership structure to another should be a smooth one.
The earnout ensures that the managers of King Co receive a certain amount for their
shares.
The managers of King Co will be incentivised to make the acquisition a success.
Ans In an earnout, the owners are not ‘bought out’ (B), but rather they are incentivised to work hard to maximise the
amount they receive (E) – which is NOT a certain amount (D).

The earnout does enable purchase consideration to be deferred (A) and should ensure a smooth transition as (C) as
the target company’s managers are retained.

50 The shareholders of Ghee Co have received a takeover offer from another company Garam
Co.

The offer is a share for share exchange of two shares in Garam Co for every five shares in
Ghee Co held.

Which THREE of the following statements are true?

The value of the consideration received by Ghee Co shareholders will be uncertain right
up until the moment the share exchange takes place.
Unlike with a cash offer, there will be no immediate tax implications for the Ghee Co
shareholders.
Garam Co will not have to borrow money to fund the takeover.

The Garam Co shareholders will retain control of the combined company.

The Ghee Co shareholders will not be able to participate in the running of the company
after the acquisition.
A share exchange (rather than a cash offer) means that there is no financing implication for the buyer (C) or tax
implication for the target company shareholders (B). Unlike a cash offer though, the value of the consideration is
uncertain (A) being dependent on the two share prices on the date of exchange.

The target company shareholders will still be involved in the running of the company after the takeover (E) but the
control of the new company cannot be identified from the information given here, so it is not necessarily true that the
Garam Co shareholders will retain a controlling interest (D).

51 Wither Co is an unlisted chemical company. It has generated a profit before interest and tax
of approximately $22 million each year for the last three years, and it expects this level of profit
to be sustainable in the future.

The average P/E ratio in the stock market is 10, and the average for chemical companies is 12.

Wither Co pays tax at a rate of 20% and it has an $18 million corporate bond in issue, with a
market value of $17 million and a coupon rate of 6%.

What is the value of Wither Co’s equity?


$264 million

$183 million

$200 million

$220 million
Ans The answer is C.

Wither Co’s profit after tax is expected to be:

80% x [$22 million – ($18 million x 6%)] = $16.7 million

So, based on a sector average P/E ratio of 12, the value of the equity is 12 x $16.7 million i.e. $200 million.

52 Paul Co intends to pay a dividend of $50,000 in one year’s time, and in two years’ time.

Thereafter, it intends to increase dividends by 4% per annum into perpetuity.

The cost of equity is 10% and the corporate tax rate is 30%.

What is the value of Paul Co’s equity using the dividend valuation model (to the nearest
$000)?
$803,000

$867,000

$716,000

$500,000

Ans The answer is A.

The value is the present value of future dividends (discounted at 10%):

(50 x 0.909) + (50 x 0.826) + [(50 x 1.04)/(0.10 – 0.04)] x 0.826 =$803,000

53 Hole Co has forecast the following post tax cash flows before financing charges:

Year 1 $5.0 million


Year 2 $6.2 million
Year 3 $6.8 million
After year 3, the cash flows are expected to grow at 1% per year into perpetuity.

Hole Co has a cost of equity of 12% and a WACC of 9%. It is funded partly be equity and partly
by a corporate bond with nominal value $20 million and market value $19 million.

What is the value of Hole Co’s equity using a discounted cash flow approach?
$57.7 million

$76.7 million

$62.3 million

$81.3 million

Ans The answer is C.

The post tax cash flows before financing charges should be discounted at the WACC, and then the market value of
debt should be deducted to leave the value of equity.

Workings:

Year 1 Year 2 Year 3 Year 4 to perpetuity


Cash flow ($m) 5.0 6.2 6.8 6.8 x 1.01
DF 9% 0.917 0.842 0.772 0.772 /(0.09 – 0.01)
PV 4.585 5.220 5.250 66.276

Overall value = $81.331 million

Value of equity = $81.331 million - $19 million = $62.331 million

54 The following valuations have been calculated for a company.

Net assets, at realisable value $4.2 million


Calculated intangible value $4.5 million
P/E valuation, using an industry average P/E ratio $8.0 million

What is the maximum a buyer should be prepared to pay for this company, based on the
given information?
$4.5 million

$8.0 million

$8.7 million

$12.5 million

Ans The answer is C.

The CIV should be added to the value of the tangible assets. Since this is higher than the P/E valuation, it represents
the maximum purchase price.

55 Harve Co has 5 million shares in issue, which are trading at $1.44, and a long term corporate
bond with a coupon rate of 6% and a nominal value of $5 million. The bond is currently trading
at $5.5 million.

Harve Co’s P/E ratio is 10 and the corporate tax rate is 20%.

What is the Harve Co’s profit before interest and tax?


$1,230,000

$1,200,000

$900,000

$720,000

Ans The answer is B.

The normal P/E valuation is based on post tax profits (i.e. “earnings”)

Therefore, Value = P/E x Earnings

In this case:

(5m x $1.44) = 10 x earnings

Therefore earnings = $720,000

Profit BEFORE interest and tax is therefore:

($720,000 x 100/80) + (6% x $5m) = $1,200,000

56 PPP is a small publishing company, which is the subject of takeover interest from a larger,
listed publishing company QQQ.

PPP’s most recent financial statements show a profit before tax of $500,000.

The average P/E ratio for listed companies is 11, while the average P/E ratio for publishing
companies is 7. In recent months, two other publishing companies have been taken over, and
have been valued using a P/E multiple of 9.

The corporate tax rate is 25%.

What is the most appropriate valuation of PPP’s equity in this situation (to the nearest
$000)?
$2.625 million

$3.375 million

$4.125 million

$4.500 million

Ans The answer is B.

The value in this takeover situation should be [$500,000 x (1-0.25)] x 9 = $3.375 million

57 Predator Co is hoping to acquire Target Co.

Relevant information is:

Predator Target
Annual earnings $5 million $2 million
P/E ratio 12 8

Predator expects that the takeover will generate synergies of $0.5 million per year, and that it
should be able to improve the performance of Target after the takeover so that it matches
Predator’s level of performance.

What is the maximum Predator should offer to the Target shareholders?


$16.0 million

$16.5 million

$20.0 million
$30.0 million

Ans The answer is D.

The improved performance after the takeover suggests that boot strapping should be used (i.e. Predator’s P/E ratio
applied to the combined earnings).

The combined company will be worth 12 x ($2m +$5m + $0.5m) = $90 million, while Predator was worth 12 x $5m =
$60 million before the takeover.

The $30 million increase in value has been created by taking over Target, so this is the maximum Predator should
pay.

58 WW intends to acquire XX by a one-for-two share for share exchange.

Details of the companies:

WW has 10 million shares in issue and generates annual earnings of $4 million. It has a P/E
ratio of 10 and hence a market capitalisation of $40 million.

XX has 5 million shares in issue and generates annual earnings of $1 million. It has a P/E ratio
of 7 and hence a market capitalisation of $7 million.

After the takeover, annual synergies of $0.5 million are anticipated, and the P/E ratio of the
combined company is expected to be 10.

What is the expected change in the share price of WW after the takeover?
No change.

10.0% increase.

37.5% increase.

8.3% decrease.

Ans The answer is B.

The share price before the takeover is $40 million / 10 million = $4.00

The value of the combined company after the takeover is: 10 x (4+1+0.5) = $55 million.

In a 1 for 2 share exchange, 2.5 million more shares will be issued, making 12.5 million WW shares in total. Hence
share price will be $55 million / 12.5 million = $4.40 i.e. 10% higher than the original $4.00 share price.
59 Gazza Co is preparing to acquire Beardo Co in a 1-for-4 share for share exchange.

Gazza Co currently has 100 million shares in issue, valued at $5 per share and Beardo Co has
60 million shares in issue, valued at $1 per share.

Synergies totalling $40 million are expected to be generated by the takeover.

What is the likely share price of Gazza Co after the acquisition?


$4.87

$5.00

$5.22

$6.00

Ans The answer is C.

The total value after the takeover will be (100m x $5) + (60m x $1) + $40m = $600 million.

A 1 for 4 share exchange will see (1/4) x 60m = 15 million new shares issued.

Therefore, share price will be $600m / 115m = $5.22

60 Which THREE of the following statements concerning management buyouts (MBOs)


are correct?
In a leveraged buyout, the managers raise all the money for the buyout from their own
personal resources.
Most MBOs are financed from a variety of financing sources.

If a venture capitalist provides mezzanine debt to help fund the MBO, the interest on this
debt has to be paid before the interest on any of the other debt of the business.
Financiers will usually accept a low level of annual return from their investment as long as
there is a clear exit route with a large return at the end of their investment.
The provider of senior debt will require a first ranking security over all the assets involved
in the MBO venture.

Ans In a leveraged buyout, most of the finance is raised by borrowings, not the management team’s personal
resources (A). Mezzanine debt is unsecured, so its interest is payable after (not before) the interest on the other debt
of the business (C).