Fundamentals Level – Skills Module

Paper F9
Financial Management

Time allowed: 3 hours 15 minutes

This question paper is divided into three sections:

Section A – ALL 15 questions are compulsory and MUST be attempted
Section B – ALL 15 questions are compulsory and MUST be attempted
Section C – BOTH questions are compulsory and MUST be attempted

Do NOT open this question paper until instructed by the supervisor.

Do NOT record any of your answers on the question paper.

This question paper must not be removed from the examination hall.
Section A – ALL 15 questions are compulsory and MUST be attempted

1. Which of the following statements is/are correct?

1) A decrease in the cost of equity leads to a fall in share price
2) Investors faced with increased competition will expect increased return as compensation
3) The cost of debt is usually higher than that the cost of preference shares

A. 2 only
B. 1 & 3 only
C. 2 & 3 only
D. 1, 2 & 3

2. A project has an initial outflow followed by years of inflows.

What would be the effect on NPV & the IRR of a decrease in the cost of capital?

NPV IRR
A Increase Decrease
B Increase No change
C Decrease No change
D Decrease Decrease

3. A ltd is considering undertaking a project that would yield annual profits (after depreciation) of
$65000 for 5 years. The initial outlay of the project would be $780,000 and the project’s assets have
a residual value of $70000 at the end of the project.

What would be the ARR of this project (through average investment method)?
A. 8.3%
B. 15.3%
C. 7.6%
D. 6.5%

4. Which of the following would be implied by a decrease in a company’s operating gearing ratio? The
company
A. Is less profitable
B. Is more risky
C. Has a lower proportion of costs that are variable
D. Has profits which are less sensitive to changes in sales volume

5. James is considering investing in the textile industry of a country Y. The risk-free rate and return on
market in country Y are 8% and 15% respectively. James has a debt/equity of 140%.

Jason a 100% equity financed company is also in the textile industry of country Y and it has a beta of
1.20. Both companies are taxed at 30%.
 What is the cost of equity for James?
A. 8%
B. 15%
C. 24.6%
D. 27.6%

6. Asset-based business valuation using net realizable values are useful in which of the following
situations?
A. When the company is being bought for the earnings/cash flow that all of its assets can produce
in the future
B. For asset stripping
C. To identify a maximum price in a takeover
D. When the company has a highly-skilled workforce

7. The following data relate to an all equity financed company

Dividend just paid $200,000

Earnings retained & invested 40%
Return on investments 15%
Cost of equity 23%

What is the market value (to the nearest $1000)?

A. $922,000
B. $1,247,000
C. $1,176,000
D. $1,784,000

8. Consider the following statements concerning currency risk.

1. Leading and lagging is a method of hedging transaction exposure
2. Matching receipts and payments is a method of hedging translation exposure

Which of the above statements is/are true?

Statement 1 Statement 2
A. False False
B. False True
C. True True
D. True False

9. Which of the following are the features of exchange traded market?

1. Customized contracts
2. Physical existence of contracts
3. Default risk
4. Initial margin requirement
 A. 1 & 3 only
B. 4 only
C. 2 & 4 only
D. 1, 2 & 3 only

10. Which of the following is least likely to be a symptom of over trading?

A. Increase in the level of the current ratio
B. Rapid increase in sales
C. High levels of inventory turnover
D. Delayed payments to suppliers

11. A company sells inventory at credit to a customer at a selling price which is below the cost of the
inventory items.

How will this transaction affect the current ratio & the quick ratio immediately after the transaction?

Current ratio Quick ratio

A. Increase Increase
B. Decrease Increase
C. Decrease No change
D. Increase Decrease

12. XYZ Company announced its intention to make a right issue of one share at $1.45 for every four
existing shares. After the announcement of the issue the share price fell by 40c to $2.20. The price
per share just prior to the right issue is $2.45 ex-dividend.

What is theoretical ex-rights price per share?

A. $2.05
B. $2.25
C. $2.37
D. $2.45

13. What is the difference between the calculation of after cost of debt and yield to maturity?
A. Time to redemption
B. Tax savings on interest
C. Redemption value
D. Market value

14. In the context of managing performance in “not for profit” organizations, which of the following
definitions is incorrect?
A. Value for money means providing a service in a way which is economical, efficient and effective
B. Economy means doing things cheaply: not spending $2 when the same thing can be bought for
$1
C. Efficiency means doing things quickly: minimizing the amount of time that is spent on a given
activity
 D. Effectiveness means doing the right things: spending funds so as to achieve the organizations
objectives

15. A new project being considered by Bond Co would require 1,500 hours of skilled labour. The current
workforce is already fully employed but more workers can be hired in at a cost of $18 per hour. The
current workers are paid $13 per hour on a project that earns a contribution of $8 per hour.

What is the relevant cost of labour to be included in the project appraisal?

A. $15000
B. $19500
C. $27000
D. $31500
Section B – ALL 15 questions are compulsory and MUST be attempted

The following scenario relates to questions 16 to 20

MA Co is listed company that plans to expand its business. One project, which will be funded via floating
rate finance, will see MA Co venturing into a new, much riskier area of the market. The other project,
funded via equity finance, will expand their current operations. Overall, there is expected to be little
change in the company’s market weighted capital gearing. Financial data for the company before the
expansion are shown below:

Financial extracts for the year ending 31 March 20X8.

$ $
Ordinary shares, par value $0.50 225
Retained earnings 801
Total Equity 1026
14% loan notes 75
9% bank loan 250
Total non- current liabilities 325

The 14% loan notes are redeemable at par in five years’ time. They have a current ex-interest market
price of $110 per $100 loan note. MA Co pays tax on profits at an annual rate of 30%. The market price
of the company’s ordinary share is currently $3.76. AM Co equity beta is estimated to be 1.2. The
systematic risk of debt may be assumed to be zero. The risk free rate is 7% and the market return
13.5%.

The estimated equity beta of the main competitor in the same industry as the new venture is 1.8 and the
competitor’s capital gearing is 60% equity and 40% debt by market values.

Two of the employees of MA Co, John and Elisa are discussing the advantages of CAPM, John said that it
only considers the systematic risk and assumes that investors have a undiversified portfolio whereas Elisa
said that it is a better model to calculate the cost of equity than the dividend growth model and take into
account a company’s level of systematic risk.

16. What is the cost of equity and loan notes of MA Co?

Equity Loan Notes

A. 15% 10%
B. 14.8% 7.5%
C. 14.8% 11.50%
D. 7% 5%

17. What is the Weighted Average Cost of capital of MA Co?

A. 13.5%
B. 14%
C. 7.5%
D. 14.8%
18. What is the risk adjusted cost of equity and risk adjusted WACC of MA Co?
Equity WACC
A. 13.5% 10%
B. 14.5% 16.1%
C. 16.1% 14.5%
D. 10% 7.5%

19. Related to advantages of CAPM which of them is correct?

JOHN ELISA
A. True True
B. False True
C. True False
D. False False

20. Which is most likely advantage of CAPM?

1. Difficult to locate information about risk free rate of return, the average return on the market and
the equity beta.
2. CAPM is really a multiple period model and can be assumed to be constant till maturity
3. It only considers the systematic risk which is true for most of investors that have diversified
portfolio
4. The relationship between required return and systematic risk has been supported by empirical
research and testing.

A. 2 & 4 only
B. 2 & 3 only
C. 1, 2 & 4 only
D. 3 & 4 only

The following scenario relates to questions 21 to 25

Giga Tech is a large UK based technology company. The company has business in three primary
categories; Hardware manufacturing, software development and consulting services. Because of the rapid
pace of technological innovation, Giga tech must make capital investments every two to four years. The
company has identified several potential investment opportunities in different fields. Company is ready to
take every project which is profitable in every field. The first of these opportunities, Tera Project, would
replace a portion of Giga.

Existing Equipment Tera Project

Annual Sales $523,000 $708,000
Cash Operating Expenses $352,000 $440,000
Annual Depreciation $40,000 $110,667
Salvage Value 0 $113,000

Recently, Giga Tech’s board of directors has become concerned with the firm’s capital budgeting
decisions and has asked management to provide a detailed explanation of the capital budgeting process.
After reviewing the report from management, the board makes the following comments in a memo:
• We are making appropriate investment decisions since the discount rate used to evaluate all potential
projects is the firm’s current weighted average cost of capital.
• Reasons of capital rationing can be soft and hard capital rationing
• Inability of management to raise additional finance in market is an internal capital rationing reason.

The company finance director has also valued a project with ARR of 12% whereas the companies
targeted ARR is 15%. His main concern is whether the project should be accepted or not?

21. Determine whether board of director’s memo is correct with regard to its statements about Giga
Tech’s capital rationing system and its method of projecting project cash flows. Identify the correct
statement
A. Statement 2 only
B. Statement 2 and 3
C. Statement 3 only
D. Neither 2 nor 3

22. Which of the following would best correct Giga Tech’s discount rate problem described in the board
of director’s memo?
A. Use other methods than NPV which are independent of change in cost of capital
B. Use a beta specific to each potential project to determine the appropriate discount rate
C. Use the cost of the firm’s equity capital to discount the cash flows of all potential projects.
D. Use the cost of the firm’s debt capital to discount the cash flows of all potential projects.

23. The decision rule to the ARR of 12% the company should?
A. Undertake the project
B. Reject the project
C. Do nothing
D. ARR is superior than IRR

24. Which of the following statements are TRUE or FALSE?

Statement 1: Profitability Index is a preferred method than NPV in case of divisible projects because
it considers strategic importance of projects

Statement 2:Restriction on lending due to government control is a hard capital rationing.

Statement 1 Statement 2
A. False False
B. False True
C. True True
D. True False

25. Which of the following method is preferred in case if all projects are strategically important, divisible
and company is facing hard capital rationing?
A. NPV
B. Equivalent Annual Cost
C. Profitability Index
The following scenario relates to questions 26 TO 30
TLQ Co, whose home currency is the dollar, trades regularly with customers in a number of different
countries. The company expects to receive €1,200,000 in six months’ time from a foreign customer.

Current exchange rates in the home country of TLQ Co are as follows:

Spot exchange rate: 4·1780–4·2080 euros per$

Six-month forward rate: 4·2302–4·2606 euros per$
Twelve-month forward rate 4·2825–4·3132 euros per$

26. Calculate the loss or gain compared to its current dollar value which TLQ Co will incur by
taking out a forward exchange contract
A. $3,521
B. $3,544
C. $1,497
D. $5,568

27. If the interest rate in the home country of TLQ Co is 4% per year, calculate the annual
interest rate in the foreign customer’s country implied by the spot exchange rate and the
twelve-month forward exchange rate.
A. 5.8%
B. 1.5%
C. 7.4%
D. 6.6%

28. Which of the following is not the internal hedging method of foreign currency risk.
A. Matching and Invoice in Home Currency
B. Money market hedging
C. Netting and Do Nothing
D. Creating Assets and Liabilities in foreign.

29. What is of the following is/are the characteristic of future contract.

1. It’s not a leveraged instrument
2. It have flexible closeout date
3. Trade on open market
4. It has fixed date of settlement
5. Tick is the smallest movement of forward contract

A. 1, 3 & 4 only
B. 2, 4 & 5 only
C. 2 & 3 only
D. 1 & 5 only
30. What is true for Currency swap transaction?
1. Initial value of swap contract is always positive for one party and negative for other party
2. The counterparties exchange notional principals in the two currencies
3. Swap contract have No default risk like forward contract.
4. Currency swaps like future contracts are traded on exchanges.

A. 2 only
B. 1, 3 & 4 only
C. 4 only
D. 2, 3 & 4 only
Section C – BOTH questions are compulsory and MUST be attempted

31. The finance director of Harvey Co is having some working capital financing problem. Harvey Co has
revenue of $30 million per year, of which 15% are cash sales. The terms of trade states that the
standard days are 45. Approximately 1% of credit sales are bad debts currently.

Trade receivables currently stand at $4.45 million and Harvey Co has a cost of short-term finance of
7% per year. The finance director is considering a proposal from a factoring company, Zof Co, which
is offering factoring with or without recourse or invoice discounting services.

Zof Co believes that it can use its expertise to reduce average trade receivables days to 30 days,
while bad debts reduced to 0.60% of sales and reducing administration costs by $40,000 per year. A
condition of the factoring agreement is that the company would also advance Harvey Co 80% of the
value of invoices raised at an interest rate of 8% per year. Zof Co would charge an annual fee of
1.25% of credit sales without recourse and 0·75% of credit sales with recourse. Assume that there
are 365 days in each year.

Required:

a) Advise whether the factor’s offer is financially acceptable to Harvey Co, both by
• With recourse arrangement
• Without recourse arrangement
(10 Marks)

b) Explain difference between factoring & invoice discounting.

(5 marks)

c) What are the factors to be considered in formulating a trade receivables management

policy? Discuss them.
(5 marks)

(Total = 20 marks)
32. Shantaram Co is concerned about its current level of debt finance. It plans to make a rights issue
and to use the funds raised to pay off some of its debt and investment in business. The rights issue
will beat a 15% discount to its current ex-dividend share price of $8·90 per share and Shantaram
Co plans to raise $150 million, out of this Shantaram wants to invest 20 million in new project which
will yield 18% before tax profit on it. Issuance cost on right issue is 1 million. Shantaram Co believes
that paying off some of its debt a n d i n v e s t m e n t i n n e w p r o j e c t will not affect its
price/earnings ratio, which is expected to remain constant.

Income statement information

$m
Turnover 472
Cost of sales 423
––––
Profit before interest and tax 49
Interest 10
––––
Profit before tax 39
Tax 12
––––
Profit after tax 27
––––
Statement of financial position information
$m
Equity
Ordinary shares ($1 nominal) 60
Reserves 80
––––
140
Long-term liabilities
8% bonds ($100 nominal) 125
–––
265

Company is ready to buy bonds at 12.5% premium to par. It is expected that bond holder will agree
to it.

Shantaram Co pays tax a rate of 30% per year.

Required:
(a) Calculate the theoretical ex rights price per share of Shantaram Co following the rights
issue.
(4 marks)

(b) Calculate and discuss whether shareholders will financially accept the proposal of using
the cash raised via the rights issue to redeem bonds and investment in new project.
 Comment in your answer on the belief Whether or not the current price/earnings ratio
will remain constant.
(12 marks)

(c) Briefly discuss the advantages of Right issue to both company and existing shareholders?
(4 marks)

(Total: 20 marks)