FM Compilation Theory PYQs

FM Compilation Theory PYQs (December 2007 – M/J 2019)
CHAPTER 1 : FINANCIAL MANAGEMENT AND FINANCIAL OBJECTIVES
1. Discuss four ways to encourage managers to achieve stakeholder objectives. (8

marks) - M/J 2019
Share option schemes

The agency problem arises due to the separation of ownership and control, and managers
pursuing their own objectives, rather than the objectives of shareholders, specifically the
objective of maximising shareholder wealth. Managers can be encouraged to achieve
stakeholder objectives by bringing their own objectives more in line with the objectives of
stakeholders such as shareholders. This increased goal congruence can be achieved by
turning the managers into shareholders through share option schemes, although the criteria
by which shares are awarded need very careful consideration.
Performance-related pay
Part of the remuneration of managers can be made conditional upon their achieving
specified performance targets, so that achieving these performance targets assists in
achieving stakeholder objectives. Achieving a specified increase in earnings per share, for
example, could be consistent with the objective of maximising shareholder wealth. Achieving
a specified improvement in the quality of emissions could be consistent with a government
objective of meeting international environmental targets. However, PRP performance
objectives need very careful consideration if they are to be effective in encouraging
managers to achieve stakeholder targets. In recent times, long-term incentive plans (LTIPs)
have been accepted as more effective than PRP, especially where a company’s
performance is benchmarked against that of its competitors.
Corporate governance codes of best practice

Codes of best practice have developed over time into recognised methods of encouraging
managers to achieve stakeholder objectives, applying best practice to many key areas of
corporate governance relating to executive remuneration, risk assessment and risk
management, auditing, internal control, executive responsibility and board accountability.
Codes of best practice have emphasised and supported the key role played by non-
executive directors in supporting independent judgement and in following the spirit of
corporate governance regulations.
Stock exchange listing regulations

These regulations seek to ensure a fair and efficient market for trading company securities
such as shares and loan notes. They encourage disclosure of price-sensitive information in
supporting pricing efficiency and help to decrease information asymmetry, one of the causes
of the agency problem between shareholders and managers. Decreasing information
asymmetry encourages managers to achieve stakeholder objectives as the quality and
quantity of information available to stakeholders gives them a clearer picture of the extent to
which managers are attending to their objectives.
Monitoring
One theoretical way of encouraging managers to achieve stakeholder objectives is to reduce
information asymmetry by monitoring the decisions and performance of managers. One form
of monitoring is auditing the financial statements of a company to confirm the quality and
validity of the information provided to stakeholders.
Prepared by: FM-E (July - December 2019)

Aini Deraman / FM / JD’19
2. Explain the nature of the agency problem and discuss the use of share option
schemes as a way of reducing the agency problem in a stock-market listed company.
(8 marks) – Dec 2008
i) The nature of the agency problem

The managers of a company acting as agents for the principals (the shareholders) may act
in ways which do not lead to shareholder wealth maximisation. The failure of managers to
maximise shareholder wealth is referred to as the agency problem.
Shareholder wealth increases through payment of dividends and through appreciation of

share prices. Since share prices reflect the value placed by buyers on the right to receive
future dividends, analysis of changes in shareholder wealth focuses on changes in share
prices. The objective of maximising share prices is commonly used as a substitute objective
for that of maximising shareholder wealth.
The agency problem arises because the objectives of managers differ from those of
shareholders: because there is a divorce or separation of ownership from control in modern
companies; and because there is an asymmetry of information between shareholders and
managers which prevents shareholders being aware of most managerial decisions.
ii) The use of share option scheme as a way of reducing the agency problem
These are rights to buy shares on a future date at a price which is fixed when the share
options are issued. Share options will encourage managers to make decisions that are likely
to lead to share price increases (such as investing in projects with positive net present
values), since this will increase the rewards they receive from share options. The higher the
share price in the market when the share options are exercised, the greater will be the
capital gain that could be made by managers owning the options.

CHAPTER 3: FINANCIAL MARKETS, MONEY MARKETS AND INSTITUTION
1. Discuss the role of financial intermediaries in providing short term finance for use
by business organisations. (4 marks) – Dec 2009
The role of financial intermediaries in providing short term finance for use by business
organization is to provide a link between investors who have surplus cash and
borrowers who have financing needs. The amount of cash provided by individual investor
may be small, whereas borrowers need large amount of cash.
The function of financial intermediaries is to aggregate invested funds in order to meet the
needs of borrowers. In so doing, they provide a convenient and readily accessible route for
business organisations to obtain necessary funds.
Small investors are likely to be averse to losing any capital value so financial intermediaries
will assume the risk of loss on short term funds borrowed by business organisations, either
individually or by pooling risks between financial intermediaries. This aspect of the role
of financial intermediaries is referred to as risk transformation. Financial intermediaries also
offer maturity transformation, in that investors can deposit funds for a long period of time
while borrowers may require funds on a short term basis only and vice versa. In this way the
needs of both borrowers and lender can be satisfied.

CHAPTER 4: WORKING CAPITAL
1. The objectives of working capital management and the central role of working
capital management in financial management. (7 marks) – Dec 2013
The objectives of working capital management are usually taken to be profitability and
liquidity. Profitability is allied to the financial objective of maximizing shareholder wealth,
while liquidity is needed in order to settle liabilities as they fall due. A company must have
sufficient cash to meet its liabilities, since otherwise it may fail. However, these two
objectives are in conflict, since liquid resources have no return or low levels of return and
hence decrease profitability. A conservative approach to working capital management will
decrease the risk of running out of cash, favoring liquidity over profitability and decreasing
risk. Conversely, an aggressive approach to working capital management will emphasize
profitability over liquidity, increasing the risk of running out of cash while increasing
profitability.
Working capital management is central to financial management for several reasons. First,
cash is the life-blood of a company’s business activities and without enough cash to meet
short-term liabilities, a company would fail. Second, current assets can account for more
than half of a company’s assets, and so must be carefully managed. Poor management of
current assets can lead to loss of profitability and decreased returns to shareholders. Third,
for SMEs current liabilities are a major source of finance and must be carefully managed in
order to ensure continuing availability of such finance.
2. Objectives of working capital management and discuss the conflict that might arise
between them. (3 marks) – Dec 2007
The objectives of working capital management are profitability and liquidity. The objective of
profitability supports the primary financial management objective, which is shareholder
wealth maximization. The objective of liquidity ensures that companies are able to meet their
liabilities as they fall due, and thus remain in business.
However, funds held in the form of cash do not earn a return, while near-liquid assets such
as short-term investments earn only a small return. Meeting the objective of liquidity will
therefore conflict with the objective of profitability, which is met by investing over the longer
term in order to achieve higher returns. Good working capital management therefore needs
to achieve a balance between the objectives of profitability and liquidity if shareholder wealth
is to be maximized.
3. Discuss whether profitability or liquidity is primary objective of working capital

management. (4 marks) – June 2010
Profitability and liquidity are usually cited as the twin objectives of working capital
management. The profitability objective reflects the primary financial management objective
of maximising shareholder wealth, while liquidity is needed in order to ensure that financial
claims on an organisation can be settled as they become liable for payment.
The two objectives are in conflict because liquid assets such as bank accounts earn very
little return or no return, so liquid assets decrease profitability. Liquid assets in fact incur an
opportunity cost equivalent either to the cost of short-term finance or to the profit lost by not
investing in profitable projects.
Whether profitability is a more important objective than liquidity depends in part on the
particular circumstances of an organisation. Liquidity may be the more important objective

when short-term finance is hard to find, while profitability may become a more important
objective when cash management has become too conservative. In short, both objectives
are important and neither can be neglected.
4. Evaluate whether Crago can be considered to be overtrading and discuss how

overtrading can be overcome. (10 marks) – M/J 2016
Rapid increase in sales revenue

Overtrading can arise as a result of a rapid increase in sales revenue which is not matched
by a corresponding increase in working capital investment. The sales revenue of Crago Co
has increased by 42·5% over the year, indicating a rapid increase in sales revenue, while
the ratio of sales income/net working capital has increased from 12 times to 86 times,
showing that working capital investment has not matched the increase in sales revenue.
Increased reliance on short-term finance
There is evidence of an increased reliance by Crago Co on short-term finance, since the
overdraft has increased by 182% from $850,000 to $2,400,000, while trade payables have
increased by 52% from $1,250,000 to $1,900,000. In addition, the proportion of current
assets financed from short-term sources has increased from 68% to 96%.
Rapid increase in current assets
Current assets may increase rapidly in line with sales volume and sales revenue. Trade
receivables have certainly increased by 100% over the period. However, inventory has only
increased by 19%, an increase which is much smaller than the increase in the sales revenue
of Crago Co.
Decline in solvency and liquidity ratios
The current ratio of Crago Co has declined from 1·5 times to 1·05 times, while its quick ratio
has remained unchanged at 0·5 times.
Overcoming overtrading
Overtrading can be overcome by increasing the long-term capital of a company. This could
be achieved by Crago Co raising either new debt finance or new equity finance.
Alternatively, the balance between the level of business activity and the amount of long-term
finance could be restored, by calling a halt to the rapid expansion of sales until Crago Co
has consolidated its financial position.

CHAPTER 5: MANAGING WORKING CAPITAL
1. How invoice discounting and factoring can aid the management of trade
receivables. (6 marks) - Dec 2013
Invoice discounting refers to the purchase of selected invoices by a financial company at a

discount to their face value. Invoice discounting can provide immediate cash to a company
rather than waiting for the invoices to be settled. Invoice discounting can therefore aid in the
management of trade receivables by accelerating cash inflow from trade receivables when
short-term cash flow problems arise.
Factoring refers to a commercial arrangement whereby a financial company takes over the
management of a company’s trade receivables. This will include invoicing customers,
accounting for sales and collections of amounts owed. Factors will advance cash to a
company against the amounts outstanding. If the client requires, insurance against bad
debts may also be provided (non-recourse factoring).
Factoring can assist in the management of trade receivables through the expertise offered
by the factoring company. This may lead to a reduction in bad debts, a decrease in the level
of trade receivables, a decrease in the amount of managerial time devoted to chasing slow
payers, and taking advantage of early settlement discounts from trade suppliers due to the
availability of cash from trade receivables.
2. Key elements of a trade receivables management policy. (7 marks) – June 2013
Credit analysis helps a company to minimise the possibility of bad debts by offering credit
only to customers who are likely to pay the money they owe. Credit analysis also helps a
company to minimise the likelihood of customers paying late, causing the company to incur
additional costs on the money owed, by indicating which customers are likely to settle their
accounts as they fall due. Furthermore, credit analysis, or the assessment of credit
worthiness, is undertaken by analysing and evaluating information relating to a customer’s
financial history. This information may be provided by trade references, bank references, the
annual accounts of a company or credit reports provided by a credit reference agency. The
depth of the credit analysis will depend on the potential value of sales to the client, in terms
of both order size and expected future trading. As a result of credit analysis, a company will
decide on whether to extend credit to a customer.
Next is credit control. Having granted credit to customers, a company needs to ensure that
the agreed terms are being followed. The trade receivables management policy will stipulate
the content of the initial sales invoice that is raised. It will also advise on the frequency with
which statements are sent to remind customers of outstanding amounts and when they are
due to be paid. It will be useful to prepare an aged receivables analysis at regular intervals,
for example, monthly, in order to focus management attention on areas where action needs
to be taken to encourage payment by clients.
Lastly is receivables collection. Ideally, all customers will settle their outstanding accounts
as and when they fall due. Any payments not received electronically should be banked
quickly in order to decrease costs and increase profitability. If accounts become overdue,
steps should be taken to recover the outstanding amount by sending reminders and making
customer visits. Legal action could be taken if necessary, although only as a last resort.

3. Discuss reasons (other than costs and benefits already calculated) why Oscar Co
may benefit from the services offered by the factoring company. (6 marks) – Dec 2018
Oscar Co may benefit from the services offered by the factoring company for a number of
different reasons, as follows:
Oscar Co will receive early payment for most of its receivables in the form of finance from
the factor. They can use this money to pay its supplier. Therefore, they will improve the
relationship with the supplier.
Oscar Co can maintain their optimum inventory levels because they will have enough
cash to pay for the inventories it needs.
The managers of Oscar Co do not have to spend their time on the problems of slow-
paying accounts receivables. Factoring company are also likely to employ staff who are
experienced and skilled at collecting payments from customers and chasing overdue
payments.
Oscar Co gets finance linked to its volume of sales. In contrast, overdraft limits tend to be
determined by historical statements of financial position.
If Oscar Co factor with recourse, they will reduce bad debts. If Oscar Co factor without
recourse, they will eliminate bad debts.
4. Discuss ways in which a company could improve the management of domestic

account receivables. (7 marks) – Dec 2007
Two areas of concern in the management of domestic accounts receivable in PKA Co are
the increasing level of bad debts as a percentage of credit sales and the excessive credit
period being taken by credit customers.
Reducing bad debts

The incidence of bad debts, which has increased from 5% to 8% of credit sales in the last
year, can be reduced by assessing the creditworthiness of new customers before offering
them credit and PKA Co needs to introduce a policy detailing how this should be done, or
review its existing policy, if it has one, since it is clearly not working very well. In order to do
this, information about the solvency, character and credit history of new clients is needed
through bank references, trade references and credit reports from credit reference agencies.
Whether credit is offered to the new customer and the terms of the credit offered can then be
based on an explicit and informed assessment of default risk.
Reduction of average accounts receivable period

Customers have taken an average of 75 days credit over the last year rather than the 30
days offered by PKA Co, i.e. more than twice the agreed credit period. As a result, PKA Co
will be incurring opportunity cost, either from the additional interest cost on the short-term
financing of accounts receivable or from the incremental profit lost by not investing the
additional finance tied up by the longer average accounts receivable period. PKA Co needs
to find ways to encourage accounts receivable to be settled closer to the agreed date.
Assuming that the credit period offered by PKA Co is in line with that of its competitors, the
company should determine whether they too are suffering from similar difficulties with late
payers. If they are not, PKA Co should determine in what way its own terms differ from those
of its competitors and consider whether offering the same trade terms would have an impact
on its accounts receivable. For example, its competitors may offer a discount for early
settlement while PKA Co does not and introducing a discount may achieve the desired
reduction in the average accounts receivable period. If its competitors are experiencing a
similar accounts receivable problem, PKA Co could take the initiative by introducing more

favourable early settlement terms and perhaps generate increased business as well as
reducing the average accounts receivable period.
5. Discuss how risks arising from granting credit to foreign customers can be
managed and reduced. (8 marks) – June 2009
When credit is granted to foreign customers, two problems may become especially
significant. First, the longer distances over which trade takes place and the more complex
nature of trade transactions and their elements means foreign accounts receivable need
more investment than their domestic counterparts. Longer transaction times increase
accounts receivable balances and hence the level of financing and financing costs. Second,
the risk of bad debts is higher with foreign accounts receivable than with their domestic
counterparts.
In order to manage and reduce credit risks, therefore, exporters seek to reduce the risk of
bad debt and to reduce the level of investment in foreign accounts receivable. One way to
reduce investment in foreign accounts receivable is to agree early payment with an importer,
for example by payment in advance, payment on shipment, or cash on delivery. These terms
of trade are unlikely to be competitive, however, and it is more likely that an exporter will
seek to receive cash in advance of payment being made by the customer.
One way to accelerate cash receipts is to use bill finance. Bills of exchange with a signed
agreement to pay the exporter on an agreed future date, supported by a documentary letter
of credit, can be discounted by a bank to give immediate funds. This discounting is without
recourse if bills of exchange have been countersigned by the importer’s bank.
Documentary letters of credit are a payment guarantee backed by one or more banks. They
carry almost no risk, provided the exporter complies with the terms and conditions contained
in the letter of credit. The exporter must present the documents stated in the letter, such as
bills of lading, shipping documents, bills of exchange, and so on, when seeking payment. As
each supporting document relates to a key aspect of the overall transaction, letters of credit
give security to the importer as well as the exporter.
Companies can also manage and reduce risk by gathering appropriate information with
which to assess the creditworthiness of new customers, such as bank references and credit
reports.
Insurance can also be used to cover some of the risks associated with giving credit to
foreign customers. This would avoid the cost of seeking to recover cash due from foreign
accounts receivable through a foreign legal system, where the exporter could be at a
disadvantage due to a lack of local or specialist knowledge. Export factoring can also be
considered, where the exporter pays for the specialist expertise of the factor as a way of
reducing investment in foreign accounts receivable and reducing the incidence of bad debts.
6. Briefly discuss how the creditworthiness of potential customers can be assessed.

(3 marks) – June 2015
The creditworthiness of potential customers can be assessed from a range of different

sources of information. Potential customers should supply a bank reference and a trade or
other reference when seeking credit on purchases. Another source of information is the
credit rating of the potential customer, which can be checked by a credit rating agency or
credit reference agency. For larger potential customers, a file can be opened where
additional information can be located, evaluated and stored, such as the annual report and
accounts of the potential customer.

CHAPTER 6: WORKING CAPITAL FINANCE
1. Assuming that Filt 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. (3 marks) – Dec 2014
If Filt Co generates a short-term cash surplus, the cash may be needed again in the near
future. In order to increase profitability, the short-term cash surplus could be invested, for
example, in a bank deposit, however, the investment selected would normally not be
expected to carry any risk of capital loss. Shares traded on a large stock market carry a
significant risk of capital loss, and hence are rarely suitable for investing short-term cash
surpluses.
2. Discuss THREE factors which determine the level of a company’s investment in

working capital. (6 marks) – Dec 2018
There are several factors which influence the level of a company’s investment in working
capital as follows:
Nature of business
The nature of business influences the level of a company’s investment in working capital
because it influences the size of the elements of working capital. A manufacturing company,
for example may have high levels of inventory and trade receivables, a service company
may have low levels of inventory and high levels of trade receivables, and supermarket
chain may have high levels of inventory and low level of trade receivables.
Terms of trade
The terms of trade related to credit policy offer to trade receivables. The terms of trade must
be comparable with the competitors and the level of receivables will be determined by the
credit period offered and the average credit period taken by customers. The longer the credit
period, the higher the working capital required as the company need more working capital to
finance the period of credit given to customer.
Cash operating cycle

The length of the operating cycle, together with the desired level of investment in current
assets, will determine the amount of working capital finance needed. Working capital policies
will therefore be formulated so as to optimize as much as possible the length of the
operating cycle and its components, which are the inventory conversion period, the
receivables conversion period and payables deferral period.
3. Identify and discuss the factors to be considered in determining the optimum level
of cash to be held by a company. (5 marks) – Dec 2012
The following factors should be considered in determining the optimum level of cash to be
held by a company, for example, at the start of a month or other accounting control period.
The transactions need for cash:

The amount of cash needed for the next period can be forecast using a cash budget, which
will net off expected receipts against expected payments. This will determine the
transactions need for cash, which is one of the three reasons for holding cash.
The precautionary need for cash:

Although a cash budget will provide an estimate of the transactions need for cash, it will be
based on assumptions about the future and will therefore be subject to uncertainty. The
actual need for cash may be greater than the forecast needs for cash. In order to provide for
any unexpected need for cash, a company can include some spare cash (a cash buffer) in
its cash balance. This is the precautionary need for cash. In determining the optimal level of
cash to be held, a company will estimate the size of this cash buffer, for example from past
experience, because it will be keen to minimise the opportunity cost of maintaining funds in
cash form.
The speculative need for cash:

There is always the possibility of an unexpected opportunity occurring in the business world
and a company may wish to be prepared to take advantage of such a business opportunity if
it arises. It may therefore wish to have some cash available for this purpose. This is the
speculative need for cash. Building ‘a war chest’ for possible company acquisitions reflects
this reason for holding cash.
The availability of finance:

A company may choose to hold higher levels of cash if it has difficulty gaining access to
cash when it needs it. For example, if a company’s bank makes it difficult to access overdraft
finance, or if a company is refused an overdraft facility, its precautionary need for cash will
increase and its optimum cash level will therefore also increase.
4. Critically discuss the similarities and differences between working capital policies,
in the following areas. (9 marks) – June 2012
i) working capital investment

ii) working capital financing
Working capital investment policy is concerned with the level of investment in current assets,
with one company being compared with another. Working capital financing policy is
concerned with the relative proportions of short-term and long-term finance used by a
company.
Working capital financing policy uses an analysis of current assets into permanent current
assets and fluctuating current assets. Working capital investment policy does not require this
analysis. Permanent current assets represent the core level of investment in current assets
that supports a given level of business activity. Fluctuating current assets represent the
changes in the level of current assets that arise .
Working capital financing policy relies on the matching principle, which is not used by
working capital investment policy. The matching principle holds that long-term assets should
be financed from a long-term source of finance.Non-current assets and permanent current
assets should therefore be financed from a long-term source, such as equity finance or bond
finance, while fluctuating current assets should be financed from a short-term source, such
as an overdraft or a short-term bank loan.
Both working capital investment policy and working capital financing policy use the terms
conservative, moderate and aggressive. In investment policy, the terms are used to indicate
the comparative level of investment in current assets on an inter-company basis. One
company has a more aggressive approach compared to another company if it has a lower
level of investment in current assets. In working capital financing policy, the terms are used
to indicate the way in which fluctuating current assets and permanent current assets are
matched to short-term and long-term finance sources.

An aggressive financing policy means that fluctuating current assets and a portion of
permanent current assets are financed from a short-term finance source. A conservative
financing policy means that permanent current assets and a portion of fluctuating current
assets are financed from a long-term source. An aggressive financing policy will be more
profitable than a conservative financing policy because short-term finance is cheaper than
long-term finance. However, an aggressive financing policy will be riskier than a
conservative financing policy because short-term finance is riskier than long-term finance.
For example, an overdraft is repayable on demand, while a short-term loan may be renewed
on less favourable terms than an existing loan. Provided interest payments are made,
however, long-term debt will not lead to any pressure on a company and equity finance is
permanent capital.
Overall, therefore, it can be said that while working capital investment policy and working
capital financing policy use similar terminology, the two policies are very different in terms of
their meaning and application. It is even possible, for example, for a company to have a
conservative working capital investment policy while following an aggressive working capital
financing policy.
5. Explain the meaning of the term ‘cash operating cycle’ and discuss the relationship
between the cash operating cycle and the level of investment in working capital. Your
answer should include a discussion of relevant working capital policy and nature of
business operation. (7 marks) – Dec 2011
The cash operating cycle is the average length of time between paying trade payables and
receiving cash from trade receivables. It is the sum of the average inventory holding period,
the average production period and average trade receivables credit period, less the average
trade payables credit period.
The relationship between the cash operating cycle and the level of investment in working
capital is that increase in the length of the cash operating cycle will increase the level of
investment in working capital. The length of the cash operating cycle depends on working
capital policy in relation to the level of investment in working capital, and on the nature of the
business operations of a company.
Working capital policy

Companies with the same business operations may have different levels of investment in
working capital as a result of adopting different working capital policies. An aggressive policy
uses lower levels of inventory and trade receivables than a conservative policy, and so will
lead to a shorter cash operating cycle. A conservative policy on the level of investment in
working capital, in contrast, with higher levels of inventory and trade receivables, will lead to
a longer cash operating cycle. The higher cost of the longer cash operating cycle will lead to
a decrease in profitability while also decreasing risk, for example the risk of running out of
inventory.
Nature of business operations

Companies with different business operation will have different cash operating cycles. There
may be little need for inventory, for example, in a company supplying business services,
while a company selling consumer goods may have very high levels of inventory

CHAPTER 7: INVESTMENT DECISION
1. Identify and explain the key stages in the capital investment decision-making
process, and the role of investment appraisal in this process. (7 marks) – June 2009
The key stages in the capital investment decision-making process are as follows:
Identifying investment opportunities

Investment opportunities or proposals could arise from analysis of strategic choices, analysis
of the business environment, research and development, or legal requirements. The key
requirement is that investment proposals should support the achievement of organisational
objectives.
Screening investment proposals

In the real world, capital markets are imperfect, so it is usual for companies to be restricted
in the amount of finance available for capital investment. Companies therefore need to
choose between competing investment proposals and select those with the best strategic fit
and the most appropriate use of economic resources.
Analysing and evaluating investment proposals

Candidate investment proposals need to be analysed in depth and evaluated to determine
which offer the most attractive opportunities to achieve organisational objectives, for
example to increase shareholder wealth. This is the stage where investment appraisal plays
a key role, indicating for example which investment proposals have the highest net present
value.
Approving investment proposals

The most suitable investment proposals are passed to the relevant level of authority for
consideration and approval. Very large proposals may require approval by the board of
directors, while smaller proposals may be approved at divisional level, and so on. Once
approval has been given, implementation can begin.
Implementing, monitoring and reviewing investments

The time required to implement the investment proposal or project will depend on its size
and complexity, and is likely to be several months. Following implementation, the investment
project must be monitored to ensure that the expected results are being achieved and the
performance is as expected. The whole of the investment decision-making process should
also be reviewed in order to facilitate organization learning and to improve future investment
decisions.

CHAPTER 8: INVESTMENT APPRAISAL USING DCF METHOD

1. Discuss four reasons why NPV is regarded as superior to IRR as an investment
appraisal technique. (8 marks) – Sept/Dec 2018
NPV and shareholder wealth

The NPV of a proposed project, if calculated at an appropriate cost of capital, is equal to the
increase in shareholder wealth which the project offers. In this way NPV is directly linked to
the assumed financial objective of the company, the maximisation of shareholder wealth.
IRR calculates the rate of return on projects, and although this can show the attractiveness
of the project to shareholders, it does not measure the absolute increase in wealth which the
project offers.
Absolute measure
NPV looks at absolute increases in wealth and thus can be used to compare projects of
different sizes. IRR looks at relative rates of return and in doing so ignores the relative size
of the compared investment projects.
Mutually-exclusive projects
In situations of mutually-exclusive projects, it is possible that the IRR method will
(incorrectly) rank projects in a different order to the NPV method. This is due to the inbuilt
reinvestment assumption of the IRR method. The IRR method assumes that any net cash
inflows generated during the life of the project will be reinvested at the project’s IRR. NPV on
the other hand assumes a reinvestment rate equal to the cost of capital. Generally NPV’s
assumed reinvestment rate is more realistic and hence it ranks projects correctly.
Changes in cost of capital

NPV can be used in situations where the cost of capital changes from year to year. Although
IRR can be calculated in these circumstances, it can be difficult to make accept or reject
decisions as it is difficult to know which cost of capital to compare it with.
2. Problems faced when undertaking investment appraisal and how these problems
can be overcome. (8 marks) – June 2010
Asset replacement decisions (Chapter 11)
The problem here is that the net present value investment appraisal method may offer
incorrect advice about when an asset should be replaced. The lowest present value of costs
may not indicate the optimum replacement period. The most straightforward solution to this
problem is to use the equivalent annual cost method. The equivalent annual cost of a
replacement period is found by dividing the present value of costs by the annuity factor or
cumulative present value factor for the replacement period under consideration. The
optimum replacement period is then the one that has the lowest equivalent annual cost.
Multiple internal rates of return (Chapter 8)
An investment project may have multiple internal rates of return if it has unconventional
cashflow, that is, cashflow that change sign over the life of the project. A mining operation,
for example, may have initial investment (cash outflow) followed by many years of
successful operation (cash inflow) before decommissioning and environmental repair (cash
outflow). This technical difficulty makes it difficult to use the internal rate of return (IRR)
investment appraisal method to offer investment advice. One solution is to use the net
present value (NPV) investment appraisal method instead of IRR, since the non-
conventional cashflow are easily accommodated by NPV. This is one area where NPV is
considered to be superior to IRR.

Project with significantly different business risk to current operations (Chapter 14)
Where a proposed investment project has business risk that is significantly different from
current operations, it is no longer appropriate to use the weighted average cost of capital
(WACC) as the discount rate in calculating the net present value of the project. WACC can
only be used as a discount rate where business risk and financial risk are not significantly
affected by undertaking an investment project. Where business risk changes significantly,
the capital asset pricing model should be used to calculate a project-specific discount rate
which takes account of the systematic risk of a proposed investment project.

CHAPTER 9: ALLOWING FOR INFLATION AND TAXATION
1. Discuss the difference between a nominal (money terms) approach and a real terms
approach to calculating net present value. (5 marks) – June 2013
A nominal (money terms) approach to investment appraisal discounts nominal cash flows
with a nominal cost of capital. Nominal cash flows are found by inflating forecast values from
current price estimates, for example, using specific inflation. Applying specific inflation
means that different project cash flows are inflated by different inflation rates in order to
generate nominal project cash flows.
A real terms approach to investment appraisal discounts real cash flows with a real cost of
capital. Real cash flows are found by deflating nominal cash flows by the general rate of
inflation. The real cost of capital is found by deflating the nominal cost of capital by the
general rate of inflation, using the Fisher equation:
(1 + real discount rate) x (1 + inflation rate) = (1 + nominal discount rate)
The net present value for an investment project does not depend on whether a nominal
terms approach or a real terms approach is adopted, since nominal cash flows and the
nominal discount rate are both discounted by the general rate of inflation to give real cash
flows and the real discount rate, respectively. Both approaches give the same net present
value.

CHAPTER 10: PROJECT APPRAISAL AND RISK
1.Critically discuss if sensitivity analysis will assist Hraxin Co in assessing the risk of
investment project ( 6 marks ) – June 2015
Sensitivity analysis assess the extent to which net present value (NPV) of an investment
project responds to changes in project variables. The lower the percentage, the more
sensitive of NPV. Sensitivity analysis is therefore concerned with calculating relative
changes in project variables.
When discussing risk in the context of investment appraisal, it is important to note that,
unlike uncertainty, risk can be quantified and measured. The probabilities of the occurrence
of particular future outcomes can be assessed, for example, and used to evaluate the
volatility of future cash flows, for example, by calculating their standard deviation.
Sensitivity analysis is usually studied in investment appraisal in relation to understanding
how risk can be incorporated in the investment appraisal process. Sensitivity analysis can
indicate the critical variables of the investment project, however, sensitivity does not give
any indication of the probability of a change in any critical variable. For example, selling
price may be a critical variable but sensitivity analysis is not able to say whether a change in
selling price is likely to occur.
Sensitivity analysis will not therefore directly assist the company in assessing the risk of the
investment project. However, it does provide useful information which helps management to
gain a deeper understanding of the investment project and which focuses management
attention on aspects of the investment project where problems may arise.
2.Critically discuss the use of sensitivity analysis and probabilities analysis as ways
of including risk in the investment appraisal process , referring in your answer to the
relactive effectiveness of each method ? (7 marks )- June 2012
Within the context of investment appraisal, risk relates to the variability of returns and so it
can be quantified. From this point of view, risk can be differentiated from uncertainty, which
cannot be quantified. Uncertainty can be said to increase with project life, while risk
increases with the variability of returns.
It is commonly said that risk can be included in the investment appraisal process by using
sensitivity analysis, which determines the effect on project net present value of a change in
individual project variables. The analysis highlights the project variable to which the project
net present value is most sensitive in relative terms. However, since sensitivity analysis
changes only one variable at a time, it ignores interrelationships between project variables.
While sensitivity analysis can indicate the key or critical variable, it does not indicate the
likelihood of a change in the future value of this variable, i.e. sensitivity analysis does not
indicate the probability of a change in the future value of the key or critical variable. For this
reason, given the earlier comments on risk and uncertainty, it can be said that sensitivity
analysis is not a method of including risk in the investment appraisal process.
Probability analysis, as its name implies, attaches probabilities to the expected future cash
flows of an investment project and uses these to calculate the expected net present value
(ENPV). The ENPV is the average NPV that would be expected to occur if an investment
project could be repeated a large number of times. The ENPV can also be seen as the mean
or expected value of an NPV probability distribution. Given the earlier discussion of risk and
uncertainty, it is clear that probability analysis is a way of including a consideration of risk in
the investment appraisal process. It is certainly a more effective way of considering the risk
of investment projects than sensitivity analysis. A weakness of probability analysis, however,
lies in the difficulty of estimating the probabilities that are to be attached to expected future
cash flows. While these probabilities can be based on expert judgement and previous
experience of similar investment projects, there remains an element of subjectivity which
cannot be escaped.

3. Critically discuss the use of probability analysis in incorporating risk into

investment appraisal (5 marks)- M/J 2016
Risk in investment appraisal refers to a range of outcomes whose probability of occurrence
can be quantified. Probability analysis can be used to calculate the values of possible
outcomes and their probability distribution, the value of the worst possible outcome and its
probability, the probability that an investment will generate a positive NPV, the standard
deviation of the possible outcomes and the expected value (mean value) of the NPV.
Standard deviation is a measure of risk in financial management.
One difficulty with probability analysis is its assumption that an investment can be repeated
many times. The expected value of the NPV, for example, is a mean or average value of
possible NPVs, while standard deviation is a measure of dispersal of possible NPVs about
the expected (mean) NPV. The expected (mean) value will not actually occur, causing
difficulties in applying and interpreting the NPV decision rule when using probability analysis.
Another difficulty with probability analysis is the question of how the probabilities of possible
outcomes are assessed and calculated. One method of determining probabilities is by
considering and analyzing the outcomes of similar investment projects from the past.
However, this approach relies on the weak assumption that the past is an acceptable guide
to the future. Assessing probabilities this way is also likely to be a very subjective process.
4.Methods of adjusting for risk and uncertainty in investment appraisals. (8 marks) –

M/J 2018
(i) Simulation
Simulation is a computer-based method of evaluating an investment project whereby the
probability distributions associated with individual project variables and interdependencies
between project variables are incorporated. Random numbers are assigned to a range of
different values of a project variable to reflect its probability distribution.
Each simulation run randomly selects values of project variables using random numbers and
calculates a mean (expected) NPV. A picture of the probability distribution of the mean
(expected) NPV is built up from the results of repeated simulation runs. The project risk can
be assessed from this probability distribution as the standard deviation of the expected
returns, together with the most likely outcome and the probability of a negative NPV.
(ii) Adjusted payback

If risk and uncertainty are considered to be the same, payback can be used to adjust for risk
and uncertainty in investment appraisal. As uncertainty (risk) increases, the payback period
can be shortened to increase the emphasis on cash flows which are nearer to the present
time and hence less uncertain. Conversely, as uncertainty (risk) decreases, the payback
period can be lengthened to decrease the emphasis on cash flows which are nearer to the
present time. Discounted payback adjusts for risk in investment appraisal in that risk is
reflected by the discount rate employed. Discounted payback can therefore be seen as an
adjusted payback method.
(iii) Risk-adjusted discount rates

The risk associated with an investment project can be incorporated into the discount rate as
a risk premium over the risk-free rate of return. The risk premium can be determined on a
subjective basis, for example, by recognising that launching a new product is intrinsically
riskier than replacing an existing machine or a small expansion of existing operations. The
risk premium can be determined theoretically by using the capital asset pricing model in an
investment appraisal context. A proxy company equity beta can be ungeared and the
resulting asset can be regeared to reflect the financial risk of the investing company, giving a

project-specific equity beta which can be used to find a project-specific cost of equity or a
project-specific discount rate.
5. Difference between risk and uncertainty, how sensitivity analysis and probability
analysis can be used to incorporate risk (8 marks) – Dec 2007
Risk refers to the situation where probabilities can be assigned to a range of expected
outcomes arising from an investment project and the likelihood of each outcome occurring
can therefore be quantified. Uncertainty refers to the situation where probabilities cannot be
assigned to expected outcomes. Investment project risk therefore increases with increasing
variability of returns, while uncertainty increases with increasing project life.
Sensitivity analysis assesses how the net present value of an investment project is affected
by changes in project variables. By using different alternative assumptions to calculate the
project’s NPV, this can be used to determine how sensitive it is to changing variables. In this
way the key or critical project variables are determined. However, sensitivity analysis does
not assess the probability of changes in project variables and so is often dismissed as a way
of incorporating risk into the investment appraisal process.
Probability analysis refers to the assessment of the separate probabilities of a number of

specified outcomes of an investment project. For example, a range of expected market
conditions and their probability for several years could be assessed. Then, the net present
values arising from combinations of future economic conditions could then be assessed and
linked to the joint probabilities of those combinations. The expected net present value
(ENPV) could be calculated, together with the probability of the worst-case scenario and the
probability of a negative net present value. In this way, the downside risk of the investment
could be determined and incorporated into the investment decision.
6.Discuss ways of incorporating risk into the investment appraisal process. (7 marks)
– June 2011
Risk and uncertainty

Risk in investment appraisal refers to the attachment of probabilities to the possible
outcomes from an investment project and therefore represents a quantified assessment of
the variability of expected returns. Uncertainty cannot be quantified by attaching probabilities
and although the terms are often used interchangeably, the difference is important in
investment appraisal.
Sensitivity analysis
This assesses the sensitivity of project NPV to changes in project variables. It calculates the
relative change in a project variable required to make the NPV zero, or the relative change in
NPV for a fixed change in a project variable. Only one variable is considered at a time. The
key or critical variables will be identified. These show where assumptions may need to be
checked and where managers could focus their attention in order to increase the likelihood
that the project will deliver its calculated benefits.
Probability analysis
This approach involves assigning probabilities to each outcome of an investment project, or
assigning probabilities to different values of project variables. The range of NPV that can
result from an investment project is then calculated, together with the joint probability of each
outcome. The mean or average NPV (the expected NPV or ENPV) which would arise if the
investment project could be repeated a large number of times will be calculated. Other
useful information are the worst outcome and its probability, the probability of a negative
NPV, the best outcome and its probability, and the most likely outcome.

Risk-adjusted discount rate

It appears to be intuitively correct to add a risk premium to the ‘normal’ discount rate to
assess a project with greater than normal risk. The theoretical approach here would be to
use the capital asset pricing model (CAPM) to determine a project-specific discount rate that
reflected the systematic risk of an investment project. This can be achieved by selecting
proxy companies whose business activities are the same as the proposed investment
project: removing the effect of their financial risk by ungearing their equity betas to give an
average asset beta; regearing the asset beta to give an equity beta reflecting the financial
risk of the investing company.
Adjusted payback
Payback can be adjusted for risk, if uncertainty is considered to be the same as risk, by
shortening the payback period. The logic here is that as uncertainty (risk) increases with the
life of the investment project, shortening the payback period for a project that is relatively
risky will require it to pay back sooner, putting the focus on cash flows that are more certain
(less risky) because they are nearer in time. Payback can also be adjusted for risk by
discounting future cash flows with a risk-adjusted discount rate, i.e. by using the discounted
payback method.

CHAPTER 11: SPECIFIC INVESTMENT DECISION
1.The attractions of leasing as a source of both short-term and long-term finance.

(5 marks)- Dec 2013
Operating leasing can act as a source of short-term finance, while finance leasing can act as
a source of long-term finance.
Operating leasing offers a solution to the obsolescence problem, whereby rapidly aging
assets can decrease competitive advantage. Where keeping up-to-date with the latest
technology is essential for business operations, operating leasing provides equipment on
short-term contracts which can usually be cancelled without penalty to the lessee. Operating
leasing can also provide access to skilled maintenance, which might otherwise need to be
bought in by the lessee, although there will be a charge for this service.
Both operating leasing and finance leasing provide access to non-current assets in cases
where borrowing may be difficult or even not possible for a company. For example, the
company may lack assets to offer as security, or it may be seen as too risky to lend to.
Since ownership of the leased asset remains with the lessor, it can be retrieved if lease
rental payments are not forthcoming.
2.Discuss how an optimal investment schedule can be formulated when capital is

rationed and investment projects are either : ( 5 marks )-Dec 2009
Divisible
With divisible projects, the assumption is made that a proportion rather than the whole
investment can be undertaken, with the net present value (NPV) being proportional to the
amount of capital invested. For divisible project, defined either the net present value of the
project divided by its initial investment, or the present value of the future cash flows of the
project divided by its initial investment. The profitability index represents the return per dollar
invested and can be used to rank the investment projects.
The limited investment funds can then be invested in the projects in the order of their
profitability indexes, with the final investment selection being a proportionate one if there is
insufficient finance for the whole project. This represents the optimum investment schedule
when capital is rationed and projects are divisible.
Non-divisible
With indivisible projects, ranking by profitability index will not necessarily indicate the
optimum investment schedule, since it will not be possible to invest in part of a project. In
this situation, the NPV of possible combinations of projects must be calculated. The most
likely combinations are often indicated by the profitability index ranking. The combination of
projects with the highest aggregate NPV will then be the optimum investment schedule.
3.Discuss the reasons why investment finance may be limited, even when a company
has attractive investment opportunities available to it (5 marks) –S/D 2015
A company should invest in all projects with a positive net present value in order to
maximise shareholder wealth. If a company does not invest in them it will not be able to
maximise shareholder wealth.
If investment finance is limited for reasons outside a company, it is called ‘hard capital
rationing’. This may rise if the company is raising new finance through the stock market if
share prices are depressed. There may be restrictions on bank lending due to government

control. This also may arise because a company is seen as too risky by potential investors if
its level of gearing is so high.
If investment funds are limited for reasons within a company, the term ‘soft capital rationing’
is used. Management may be reluctant to issue additional share capital because of concern
that this may   lead to outsiders gaining control of the business. Management may also be
unwilling to issue additional share capital if it will lead to a dilution of   earnings per share.
Managers and directors may limit investment finance solely from retained   earnings to avoid
some consequences of external financing.
4.Discuss reasons why the company (internal) may have decided to limit investment
funds for the next year. ( 6 marks ) – June 2014
When a company restricts or limits investment funds, it is undertaking ‘soft’ or internal capital
rationing. Capital rationing means that a company is unable to invest in all projects with a
positive net present value and hence it is not acting to maximise shareholder wealth.
There are several reasons why the company may have decided to limit investment funds for
the next year. It may not wish to issue new equity finance in order to avoid diluting earning
per share. Issuing new equity finance may also increase the risk of a company’s shares
being bought by a potential acquirer, leading to a future takeover bid.
The company may not wish to issue new debt finance if it wishes to avoid increasing its
commitment to fixed interest payments. This could be because economic prospects are
seen as poor or challenging, or because existing debt obligations are high.
The company may wish to follow a strategy of organic growth by financing capital investment
projects from retained earnings rather than seeking additional external finance.
The company may wish to create an internal market for capital investment funds, so that
capital investment proposals must compete for the limited funds made available in the
budget set by theboard. This competition would mean that only robust capital investment
projects would be funded, while marginal capital investment projects would be rejected.
5. Discuss the nature and causes of the problem of capital rationing in the context of
investment appraisal and explain how this problem can be overcome in reaching the
optimal investment decision for a company. ( 7 marks ) – Dec 2011
In capital investment decisions, companies are limited in the funds that are available for
investment. However, the basis for investment decisions should still be to maximise the
wealth of shareholders. The NPV decision rule calls for a company to invest in all projects
with a positive net present value, but this is theoretically possible only in a perfect capital
market. Since investment funds are limited ,it is not possible for a company to invest in all
projects with a positive NPV. The reasons why investment funds are limited are either
external to the company (hard capital rationing) or internal to the company (soft capital
rationing).
Several reasons have been suggested for hard capital rationing, such as that investors may
feel that a company is too risky to invest in, with its credit rating being seen as too low for the
amount of investment it needs. Perhaps capital markets may be depressed, so that there is
a general unwillingness by investors to provide funds for capital investment. Capital may be
in short supply due to ‘crowding-out’ as a result of high government borrowing.
Soft capital rationing may be due to reluctance by a company to raise finance. For example,
the amount of funds needed may be small in relation to the costs of raising the finance: or

the company may wish to avoid dilution of control or earnings per share by issuing new
equity; or the company may wish to avoid a commitment to paying fixed interest because it
believes future economic conditions may put its profitability under pressure.
If a company cannot invest in all projects with a positive NPV, it must ensure that it
generates the maximum return per dollar invested. With single-period capital rationing,
where investment funds are limited in the first year only, divisible investment projects can be
ranked in order of desirability using the profitability index. This can be defined either as the
NPV divided by the initial investment, or as the present value of future cash flows divided by
the initial investment. The optimal investment decision for a company is then to invest in the
projects in turn, moving from highest profitability index downwards, until all the funds have
been exhausted. This may require partial investment in the last desirable project selected,
which is possible with divisible investment projects.
Where investment projects are not divisible, the total NPV of various combinations of
projects must be compared, within the limit of the investment funds available, in order to
select the combination of projects with the highest NPV. This will be the optimum investment
decision. Surplus funds may be left over, but since the highest-NPV combination has been
selected, the amount of surplus funds is irrelevant to the selection of the optimal investment
schedule. Investing these surplus funds in a bank or in the money market would have an
NPV of zero.

CHAPTER 12: SOURCES OF FINANCE
1.Discuss the factors to be considered by company in choosing to raise funds via

right issues. (6 marks) –Dec 2014
A rights issue raises equity finance by offering new shares to existing shareholders in
proportion to the number of shares they currently hold. Existing shareholders have the right
to be offered new shares before they are offered to new investors. There are a number of
factors which Tinep Co should consider.
Issue price
Rights issues shares are offered at a discount to the market value. It can be difficult to judge
what the amount of the discount should be.
Relative cost
Rights issues are cheaper than other methods of raising finance by issuing new equity, such
as an initial public offer (IPO) or a placing, due to the lower transactions costs associated
with rights issues.
Ownership and control

As the new shares are being offered to existing shareholders, there is no dilution of
ownership and control, providing shareholders take up their rights.
Gearing and financial risk
Increasing the weighting of equity finance in the capital structure of Tinep Co can decrease
its gearing and its financial risk. The shareholders of the company may see this as a positive
move, depending on their individual risk preference positions.
2.The concept of Riba (interest) and how returns are made by Islamic financial
instruments. (5 marks)-Dec 2013
Interest (riba) is the predetermined amount received by a provider of finance, over and
above the principal amount of finance provided. Riba is absolutely forbidden in Islamic
finance. Riba can be seen as unfair from the perspective of the borrower, the lender and the
economy.
Islamic financial instruments require that an active role be played by the provider of funds,
so that the risks and rewards of ownership are shared. In a Mudaraba contract, for example,
profits are shared between the partners in the proportions agreed in the contract, while
losses are borne by the provider of finance. In a Musharaka contract, profits are shared
between the partners in the proportions agreed in the contract, while losses are shared
between the partners according to their capital contributions. With Sukuk, certificates are
issued which are linked to an underlying tangible asset and which also transfer the risk and
rewards of ownership. The underlying asset is managed on behalf of the Sukuk holders. In a
Murabaha contract, payment by the buyer is made on a deferred or instalment basis.
Returns are made by the supplier as a mark-up is paid by the buyer in exchange for the right
to pay after the delivery date. In an Ijara contract, which is equivalent to a lease agreement,
returns are made through the payment of fixed or variable lease rental payments.
3.Evaluate suitable method of raising the $200 million requied by Nugfer Co,
supporting your evaluation with analysis and critical discussion. (15 marks)- Dec 2010
Recent financial performance

(calculation required)
One positive feature indicated by this analysis is the growth in revenue, which grew by 23%
in 2009 and by 21% in 2010. Slightly less positive is the growth in operating profit, which

was 16% in 2009 and 13% in 2010. Both years were significantly better in revenue growth
and operating profit growth than 2008. One query here is why growth in operating profit is so
much lower than growth in revenue. Better control of operating and other costs might
improve operating profit substantially and decrease the financial risk of Nugfer Co.
The growing financial risk of the company is a clear cause for concern. The interest
coverage ratio has declined each year in the period under review and has reached a
dangerous level in 2010. The increase in operating profit each year has clearly been less
than the increase in finance charges, which have tripled over the period under review. The
reason for the large increase in debt is not known, but the high level of financial risk must be
considered in selecting an appropriate source of finance to provide the $200m in cash that is
needed.
Current financial position

The current financial position of Nugfer Co will be considered by potential providers of
finance in their assessment of the financial risk of the company. Analysis of the current
financial position of Nugfer Co shows the following:
Debt/equity ratio = long-term debt/total equity = 100 x (100/221) = 45%
Debt equity/ratio including short-term borrowings = 100 x ((100 + 160)/221) = 118%
The debt/equity ratio based on long-term debt is not particularly high. However, the interest
coverage ratio indicated a high level of financial risk and it is clear from the financial position
statement that the short-term borrowings of $160m are greater than the long-term
borrowings of $100m. In fact, short-term borrowings account for 62% of the debt burden of
Nugfer Co.
If we include the short-term borrowings, the debt/equity ratio increases to 118%, which is
certainly high enough to be a cause for concern. The short-term borrowings are also at a
higher interest rate (8%) than the long-term borrowings (6%) and as a result, interest on
short-term borrowings account for 68% of the finance charges in the income statement.
It should also be noted that the long-term borrowings are bonds that are repayable in 2012.
Nugfer Co needs therefore to plan for the redemption and refinancing of $100m of debt in
two years’ time, a factor that cannot be ignored when selecting a suitable source of finance
to provide the $200m of cash needed.
Recommendation of suitable financing method

There are strong indications that it would be unwise for Nugfer Co to raise the $200m of
cash required by means of debt finance, for example the low interest coverage ratio and the
high level of gearing.
(show calculation based on question)
If convertible debt were used, the increase in gearing and the decrease in interest coverage
would continue only until conversion occurred, assuming that the company’s share price
increased sufficiently for conversion to be attractive to bondholders. Once conversion
occurred, the debt capacity of the company would increase due both to the liquidation of the
convertible debt and to the issuing of new ordinary shares to bond holders. In the period until
conversion, however, the financial risk of the company as measured by gearing and interest
coverage would remain at a very high level.
If Nugfer Co were able to use equity finance, the interest coverage ratio would increase to
4·5 times and the debt/equity ratio would fall to 100 x (260/(221 + 200)) = 62%. Although the
debt/equity ratio is still on the high side, this would fall if some of the short-term borrowings
were able to be paid off, although the recent financial performance of Nugfer Co indicates
that this may not be easy to do. The problem of redeeming the current long-term bonds in
two years also remains to be solved.
However, since the company has not paid any dividend for at least four years, it is unlikely
that current shareholders would be receptive to a rights issue, unless they were persuaded
that dividends would be forthcoming in the near future. Acquisition of the competitor may be
the only way of generating the cash flows needed to support dividend payments. A similar

negative view could be taken by new shareholders if Nugfer Co were to seek to raise equity
finance via a placing or a public issue.
Sale and leaseback of non-current assets could be considered, although the nature and
quality of the non-current assets is not known. The financial position statement indicates that
Nugfer Co has $300m of non-current assets, $100m of long-term borrowings and $160m of
short-term borrowings. Since its borrowings are likely to be secured on some of the existing
non-current assets, there appears to be limited scope for sale and leaseback.
Venture capital could also be considered, but it is unlikely that such finance would be
available for an acquisition and no business case has been provided for the proposed
acquisition.
4. Factors to be considered in choosing between traded bonds, new equity issued via
a placing and venture capital as sources of finance. ( 9 marks) –June 2013
Traded bonds are debt securities issued onto the capital market in exchange for cash
received by the issuing company. The cash raised must be repaid on the redemption date,
usually between five and fifteen years after issue. Bonds are usually secured on non-current
assets of the issuing company, which reduces the risk to the lender. In the event of default
on interest payments by the borrower, the bond holders can appoint a receiver to sell the
assets and recover their investment. Interest paid on the bonds is tax-deductible, which
reduces the cost of debt to the issuing company. Provided the borrower continues to pay the
interest, however, bond finance is a low risk financing choice by the issuer.
There are number of differences between bond finance and a new equity issue via a placing
that will influence the choice between them. Equity finance does not need to be redeemed,
since ordinary shares are truly permanent finance. While bond interest is usually fixed, the
return to shareholders in the form of dividends depends on the dividend decision made by
the directors of a company, and so these returns can increase, decrease or be passed.
Furthermore, since dividends are a distribution of after-tax profit, they are not tax-deductible
like interest payments, and so equity finance is not tax-efficient like debt finance.
Venture capital is found in specific financing situations, i.e. where risk finance is needed, for
example, in a management buyout. Both equity and debt finance can be part of a venture
capital financing package, but the return expected on venture capital is very high because of
the level of risk faced by the investor.
5.Evaluate the proposal to use the bond issue to finance reduction in overdraft and
discuss alternative sources of finance that could be considered. ( 12 marks ) –June
2010
Interest coverage ratio

The current interest coverage ratio of 4·4 times is just over half of the sector average value
of 8 times, although before the fall in profit it was 22 times. As a result of the bond issue, the
interest coverage ratio would fall to 2·6 times, which is a dangerously low level of cover.
Gearing
Whether the bond issue has an effect on gearing depends on whether the gearing
calculation includes the overdraft. If the overdraft is excluded, gearing measured by the
debt/equity ratio on a market value basis increases from zero to 9·8%. If the overdraft is
included, there is no change in gearing, since the bond issue replaces an equal amount of
the overdraft. Given the sector average debt/equity of 10%, there does not appear to be any
concerns about gearing as a result of the bond issue.
Security
It is very likely that the bond issue would need to be secured against the tangible non-
current assets of YGV Co, especially in light of the recent decline in profitability. However,

the bond issue is for $4 million while the tangible non-current assets of YGV Co have a
value of only $3 million. It is not known whether the intangible non-current assets can be
used as security, since their nature has not been disclosed.
Advisability of using the bond issue to reduce the overdraft

Considering the significant decrease in the interest coverage ratio as a result of the bond
issue and the lack of tangible non-current assets to offer as security, it appears that the
proposed bond issue cannot be recommended and would probably be unsuccessful. YGV
Co should therefore consider alternative sources of finance in order to reduce the overdraft.
Alternative sources of finance

If longer-term viability is assured, the need for further finance could be reduced by taking
measures to reduce costs and increase income, for example through improved working
capital management.
If the company pays dividends, consideration could be given to reducing or passing the
dividend in order to increase the flow of retained earnings in the company.
Given the problems with interest coverage and security, and the lack of availability of further
overdraft finance, equity finance is the first alternative choice that could be considered.
While no information has been provided on recent share price changes or on the dividend
policy of YGV Co, existing shareholders could be consulted about a rights issue
Other finance sources that could be considered include convertible bonds or bonds with
warrants attached. Improved working capital management could also decrease the amount
of finance required.
6.Discuss the attractions to a company of convertible debt compared to a bank loan

of a similar maturity as a source of finance. ( 4 marks ) – Dec 2012
Convertible debt is debt that, at the option of the holder, can be converted into ordinary
shares. If not converted, it will be redeemed like ordinary or straight debt on maturity.
Convertible debt has a number of attractions compared with a bank loan of similar maturity,
as follows:
Self-liquidating
Provided that the conversion terms are pitched correctly and expected share price growth
occurs, conversion will be an attractive choice for bond holders as it offers more wealth than
redemption. This occurs when the conversion value is greater than the redemption value (if
conversion and redemption are on the same date), or when the conversion value is greater
than the floor value on the conversion date (if conversion is at an earlier date than the
redemption date). If the debt is converted into ordinary shares, it will not need to be
redeemed, i.e. self-liquidation has occurred. A bank loan of a similar maturity will need to
have all of the capital repaid.
Lower interest rate

The interest rate on convertible debt will be lower than the interest rate on ordinary debt
such as a bank loan because of the value of the option to convert. The returns on fixed-
interest debt will not increase with corporate profitability, so debt providers will have a limited
share of the benefits from the investment of the funds they have provided. When debt has
been converted, however, bond holders become shareholders and will potentially have
unlimited returns, or at least returns that are higher than the returns on debt finance.
Incrase in debt capacity on conversion

Gearing will increase with a bank loan for the time that the debt is outstanding, and gearing
will then return to its previous level when the bank loan has been paid off. Gearing also
increases when convertible debt is issued, but if conversion occurs, the gearing will fall not
only because the debt has been removed, but will fall even further because equity has

replaced the debt. The capacity of the company to service debt (debt capacity) will therefore
be enhanced by conversion, compared to redemption of a bank loan of a similar maturity.
More attractive than ordinary debt

It may be possible to issue convertible debt even when ordinary debt such as a bank loan is
not attractive to lenders, since the option to convert offers a little extra that ordinary debt
does not. This is the option to convert in the future, which can be attractive to optimists, even
when the short- and medium-term economic outlook may be poor.
7.Explain the nature of a mudaraba contract and discuss briefly how this form of
Islamic finance could be used to finance the planned business expansion .(5 marks)-
June 2012
One central principle of Islamic finance is that making money out of money is not
acceptable, hence interest is prohibited.
A mudaraba contract, in Islamic finance, is a partnership between one party that brings
finance or capital into the contract and another party that brings business expertise and
personal effort into the contract. The first party is called the owner of capital, while the
second party is called the agent, who runs or manages the business.
The mudaraba contract specifies how profit from the business is shared proportionately
between the two parties. Any loss, however, is borne by the owner of capital, and not by the
agent managing the business. It can therefore be seen that three key characteristics of a
mudaraba contract are that no interest is paid, that profits are shared, and that losses are
not shared.
If company were decide to seek Islamic finance for the planned business expansion and if
the company were to enter into a mudaraba contract, the company would therefore be
entering into a partnership as an agent, managing the business and sharing profits with the
Islamic bank that provided the finance and which was acting as the owner of capital. The
Islamic bank would not interfere in the management of the business and this is what would
be expected if company were to finance the business expansion using debt such as a bank
loan. However, while interest on debt is likely to be at a fixed rate, the mudaraba contract
would require a sharing of profit in the agreed proportions.
8. Analyse and discuss the relative merits of a right issue, a placing and an issue of
bonds as ways of raising the finance of expansion. ( 7 marks ) – June 2009
The current debt/equity ratio of JJG Co is 42% (20/47·5). Although this is less than the
sector average value of 50%, it is more useful from a financial risk perspective to look at the
extent to which interest payments are covered by profits.
2008 2007 2006 2005
Profit before interest and tax ($m) 9·8 8·5 7·5 6·8
Bond interest ($m) 1·6 1·6 1·6 1·6
Interest coverage ratio (times) 6·1 5·3 4·7 4·3
The interest on the bond issue is $1·6 million (8% of $20m), giving an interest coverage ratio
of 6·1 times. If JJG Co has overdraft finance, the interest coverage ratio will be lower than
this, but there is insufficient information to determine if an overdraft exists. The interest
coverage ratio is not only below the sector average, it is also low enough to be a cause for
concern. While the ratio shows an upward trend over the period under consideration, it still
indicates that an issue of further debt would be unwise.

A placing, or any issue of new shares such as a rights issue or a public offer, would
decrease gearing. If the expansion of business results in an increase in profit before interest
and tax, the interest coverage ratio will increase and financial risk will fall. Given the current
financial position of JJG Co, a decrease in financial risk is certainly preferable to an
increase.
A placing will dilute ownership and control, providing the new equity issue is taken up by
new institutional shareholders, while a rights issue will not dilute ownership and control,
providing existing shareholders take up their rights. A bond issue does not have ownership
and control implications, although restrictive or negative covenants in bond issue documents
can limit the actions of a company and its managers.
All three financing choices are long-term sources of finance and so are appropriate for a
long-term investment such as the proposed expansion of existing business.
Equity issues such as a placing and a rights issue do not require security. No information is
provided on the non-current assets of JJG Co, but it is likely that the existing bond issue is
secured. If a new bond issue was being considered, JJG Co would need to consider whether
it had sufficient non-current assets to offer as security, although it is likely that new non-
current assets would be bought as part of the business expansion.
9.Sources and characteristics of long-term debt finance. ( 8 marks ) – June 2014
Long-term bank loan

Long-term bank loan could be obtain either from a single bank or from a syndicate of banks.
Interest payments on the bank loan could be annual, twice yearly or quarterly, and at either
a fixed rate or a floating rate of interests. It is likely that the bank loan would be secured
against particular non-current assets of company, so that the bank could recover its loan if
the company defaults on interest payments.
Convertible bonds
Convertible bonds are bonds which at the option of the holder, can be converted into a
specified quantity of ordinary shares on a specified future date. Convertible bonds can pay
interest annually or twice annually, at a fixed or a floating rate of interest The future option to
convert into equity has value to investors and as a consequence, the interest rate on
convertible debt is lower than that on ordinary bonds. If conversion does not take place,
however, redemption of the bonds or loan notes will be required.
Bonds or loan notes

Bonds or loan notes may be redeemable or irredeemable. Fixed rate or floating rate interest
is paid on the bonds, either annually or half yearly, with the interest being based on nominal
(par) value of the bonds rather than on their market value. Bonds also are mainly traded on
the capital markets and can be issued in a variety of foreign currencies. The return required
on debt finance (the cost of debt) is lower than return required on equity (cost of capital) and
so company could reduce its average cost of capital by issuing debt finance, as it is currently
financed by equity alone.
Deep discount bonds

The return to a bond holder consists of regular interest payments (income) and repayment of
the principle amount on redemption (capital). Investors may accept lower interest payments
in exchange for an increase in capital return. This can be achieved if the bond is issued at a
deep discount to nominal value, but redeemed at nominal value. This kind of financial

security is called a deep discount bond and may be suitable for companies which do not
expect an immediate return on invested capital.
Zero coupon bonds

A zero coupon bond goes a step further from deep discount bond and pays no interest
(coupon) at all, so that the return to the investor is entirely in the form of capital appreciation.
Bonds like these are useful for companies which expect cash flows from invested capital to
occur mainly later in the life of an investment project, rather than more evenly throughout its
life.
10.The advantages of using convertible loan notes as a source of long-term finance

could be discussed. ( 6 marks ) – Sept/Dec 2017
Conversion rather than redemption

If the holders of convertible loan notes judge that conversion into ordinary shares will
increase their wealth, conversion of the loan notes will occur on the conversion date and
Tufa Co will not need to find the cash needed to redeem the loan notes. This is sometimes
referred to as ‘self-liquidation’.
Lower interest rate

The option to convert into ordinary shares has value for investors as ordinary shares
normally offer a higher return than debt. Investors in convertible loan notes will therefore
accept a lower interest rate than on ordinary loan notes, decreasing the finance costs for the
issuing company.
Attractive to investors
Tufa Co may be able to issue convertible loan notes to raise long-term finance even when
investors might not be attracted by an issue of ordinary loan notes, because of the attraction
of the option to convert into ordinary shares in the future.
11. Reasons why a company may choose to finance a new investment by an issue of
debt finance. ( 7 marks ) – Dec 2008
Pecking order theory suggests that companies have a preferred order in which they seek to
raise finance, beginning with retained earnings. The advantages of using retained earnings
are that issue costs are avoided by using them, the decision to use them can be made
without reference to a third party, and using them does not bring additional obligations to
consider the needs of finance providers.
Once available retained earnings have been allocated to appropriate uses within a
company, its next preference will be for debt. One reason for choosing to finance a new
investment by an issue of debt finance, therefore, is that insufficient retained earnings are
available and the investing company prefers issuing debt finance to issuing equity finance.
Debt finance may also be preferred when a company has not yet reached its optimal capital
structure and it is mainly financed by equity, which is expensive compared to debt. Issuing
debt here will lead to a reduction in the WACC and hence an increase in the market value of
the company. One reason why debt is cheaper than equity is that debt is higher in the
creditor hierarchy than equity, since ordinary shareholders are paid out last in the event of
liquidation.
Debt is even cheaper if it is secured on assets of the company. The cost of debt is reduced
even further by the tax efficiency of debt, since interest payments are an allowable deduction
in arriving at taxable profit.

Debt finance may be preferred where the maturity of the debt can be matched to the
expected life of the investment project. Equity finance is permanent finance and so may be
preferred for investment projects with long lives.
12.Explain the difference between Islamic finance and other conventional finance. (4
marks)- March/ June 2016
In Islamic finance, risk and rewards in term of economic benefits are shared between the
provider of finance and the user of finance. Economic benefits includes employment and
social welfare. While conventional finance which is not based on the Islamic principles, does
not require the sharing of risk and rewards between the provider and the user of finance.
Riba (interest) is absolutely forbidden in Islamic finance and is seen immoral. But under the
conventional finance it is seen as the main form of return to the debt holder. In the
conventional financial system, interest is the reward for depositing fund and the cost for
borrowing fund.
Murabaha and Sukuk are part of Islamic finance which can be compared to the conventional
debt. However, Murabaha and Sukuk must have a direct link with underlying tangible asset.
Islamic finance can only support business activities which are acceptable under Sharia Law.
13. Islamic Finance sources which could consider as alternative to a right issue or
loan note issue. (6 marks ) – March / June 2018
Mudaraba
A mudaraba contract is between a capital partner (rab al mal) and an expertise partner
(mudarab) for the undertaking of business operations. The business operations must be
compliant with Sharia’a law and are run on a day-to-day basis by the mudarab. The rab al
mal has no role in relation to the day-to-day operations of the business.Profits from the
business operations are shared between the partners in a proportion agreed in the contract.
Losses are borne by the rab al mal alone, as provider of the finance, up to the limit of the
capital provided.
Sukuk
Conventional loan notes are not allowed under Sharia’a law because there must be a link to
an underlying tangible asset and because interest (riba) is forbidden. Sukuk are linked to an
underlying tangible asset, ownership of which is passed to the sukuk holders, and do not
pay interest.Since the sukuk holders take on the risks and rewards of ownership, sukuk also
has an equity aspect. As owners, sukuk holders will bear any losses or risk from the
underlying asset. In terms of rewards, sukuk holders have a right to receive the income
generated by the underlying asset and have a right to dismiss the manager of the underlying
asset, if this is felt to be necessary.
Ijara
In this form of Islamic finance, the lessee uses a tangible asset in exchange for a regular
rental payment to the lessor, who retains ownership throughout the period of the lease
contract. The contract may allow for ownership to be transferred from thelessor to the lessee
at the end of the lease period. Major maintenance and insurance are the responsibility of the
lessor, while minor or day-to-day maintenance is the responsibility of the lessee. The lessor
may choose to appoint the lessee as their agent to undertake all maintenance, both major
and minor.

14. Discuss the attraction of operating leasing as a source of finance. ( 6 marks ) –

Dec 2007
Operating leasing is a source of finance of choice for many companies for many reasons.
For example, an operating lease is seen as protection against obsolescence, since it can be
cancelled at short notice without financial penalty. The lessor will replace the leased asset
with a more up-to-date model in exchange for continuing leasing business. This flexibility is
seen as valuable in the current era of rapid technological change, and can also extend to
contract terms and servicing cover.
There is no need to arrange a loan in order to acquire an asset and so the commitment to
interest payments can be avoided, existing assets need not be tied up as security and
negative effects on return on capital employed can be avoided. Since legal title does not
pass from lessor to lessee, the leased asset can be recovered by the lessor in the event of
default on lease rentals. Operating leasing can therefore be attractive to small companies or
to companies who may find it difficult to raise debt.
Operating leasing can also be cheaper than borrowing to buy such as by taking advantage
of bulk buying, or by having access to lower cost finance especially for larger company. The
lessor may also be able use tax benefits more effectively than the lessee resulting in lower
lease rentals, making it a more attractive proposition that borrowing.
15. Discuss the factors that influence the market value of traded bonds. ( 5 marks ) –
June 2011
Amount of interest payment

The market value of a traded bond will increase as the interest paid on the bond increases,
since the reward offered for owning the bond becomes more attractive.
Frequency of interest payments

If interest payments are more frequent, say every six months rather than every year, then
the present value of the interest payments increases and hence so does the market value.
Redemption value
If a higher value than par is offered on redemption, as is the case with the proposed bond
issue of AQR Co, the reward offered for owning the bond increases and hence so does the
market value.
Period to redemption
The market value of traded bonds is affected by the period to redemption, either because
the capital payment becomes more distant in time or because the number of interest
payments increases.
Cost of debt
The present value of future interest payments and the future redemption value are heavily
influenced by the cost of debt, i.e. the rate of return required by bond investors. This rate of
return is influenced by the perceived risk of a company, for example as evidenced by its
credit rating. As the cost of debt increases, the market value of traded bonds decreases, and
vice versa.
Convertibility
If traded bonds are convertible into ordinary shares, the market price will be influenced by
the likelihood of the future conversion and the expected conversion value, which is
dependent on the current share price, the future share price growth rate and the conversion
ratio.

16. Discuss the factors that THP Co should consider, in its circumstances, in
choosing between equity finance and debt finance as sources of finance from which
to make the cash offer for CRX Co. ( 8 marks ) – June 2008
Current gearing level: 68.5% ($5000/$7300 x 100)

It is important for a company to keep its gearing level at the lowest possible as it may show
how risky the company is. Currently, THP Co’s gearing is at 68.5% and will decrease to 45%
if equity finance is taken and will increase to 121% if debt is taken. Even so, THP Co would
acquire debt finance from CRX Co after buying the company. THP Co would have to
reconsider on which finance would benefit in terms of corporate risk and stakeholder risk.
Target Capital Structure

THP Co would have to reconsider in the changing of the company’s capital structure after
acquiring CRX Co. As a whole, a company’s main objective is to maximise shareholder’s
wealth and minimise weighted average cost of capital. In this case can be achieved as debt
finance is relatively cheaper as compared to equity finance.
Availability of Security
When choosing between debt and equity finance, a company will have to ensure that they
have sufficient security. Debts will usually be secured on assets on fixed charge or floating
charge. In order to acquire CRX Co, THP Co would need to secure using fixed charge on
specific assets however information on this is not provided.
Economic expectations
If THP Co increase profitability in future, it will be more prepared to take on fixed interest
debt commitments than if the company believe difficult trading conditions in near future.
Control Issues
The issuance of right issue will not dilute the control of existing shareholders unless existing
shareholders refuse to take up the offer, and the company will issue shares to public.

CHAPTER 13: DIVIDEND POLICY
1.Discuss the factor to be considered in formulating the dividend policy of a stock-

exchange listed company (10 marks)-Dec 2010
Profitability
Companies need to remain profitable and dividends are a distribution of after-tax profit. A
company cannot consistently pay dividends higher than its profit after tax. A healthy level of
retained earnings is needed to finance the continuing business needs of the company.
Liquidity
Although a dividend is a distribution of profit, it is a cash payment by the company to its
shareholders. A company must therefore ensure it has sufficient cash to pay a proposed
dividend and that paying a dividend will not compromise day-to-day cash financing needs.
The need for finance

There is a close relationship between investment, financing and dividend decisions, and the
dividend decision must consider the investment plans and financing needs of the company.
A large investment programme, for example, will require a large amount of finance, and the
need for external finance can be reduced if dividend increases are kept in check. Similarly,
the decision to increase dividends may reduce retained earnings to the extent where
external finance is needed in order to meet investment needs.
The level of financial risk

If financial risk is high, for example due to a high level of gearing arising from a substantial
level of debt finance, maintaining a low level of dividend payments can result in a high level
of retained earnings, which will reduce gearing by increasing the level of reserves. The cash
flow from a higher level of retained earnings can also be used to decrease the amount of
debt being carried by a company.
The signalling effect of dividends

In a semi-strong form efficient market, information available to directors is more substantial
than that available to shareholders, so that information asymmetry exists. This is one of the
causes of the agency problem. If dividend decisions convey new information to the market,
they can have a signalling effect concerning the current position of the company and its
future prospects. The signalling effect also depends on the dividend expectations in the
market. A company should therefore consider the likely effect on share prices of the
announcement of a proposed dividend.
2.Discuss whether a change in dividend policy will affect the share price of DD Co. ( 7
marks ) –Dec 2009
Miller and Modigliani showed that, in a perfect capital market, the value of a company
depended on its investment decision alone, and not on its dividend or financing decisions. A
change in dividend policy by DD Co would not affect its share price or its market
capitalisation. They showed that the value of a company was maximised if it invested in all
projects with a positive net present value (its optimal investment schedule). The company
could pay any level of dividend and if it had insufficient finance, make up the shortfall by
issuing new equity. Since investors had perfect information, they were indifferent between
dividends and capital gains. Shareholders who were unhappy with the level of dividend
declared by a company could gain a ‘home-made dividend’ by selling some of their shares.
This was possible since there are no transaction costs in a perfect capital market.
Against this view are several arguments for a link between dividend policy and share prices.
For example, it has been argued that investors prefer certain dividends now rather than

uncertain capital gains in the future (the ‘bird-in-the-hand’ argument). It has also been
argued that real-world capital markets are not perfect, but semi-strong form efficient. Since
perfect information is therefore not available, it is possible for information asymmetry to exist
between shareholders and the managers of a company. Dividend announcements may give
new information to shareholders and as a result, in a semi-strong form efficient market,
share prices may change. The size and direction of the share price change will depend on
the difference between the dividend announcement and the expectations of shareholders.
This is referred to as the ‘signalling properties of dividends’.
It has been found that shareholders are attracted to particular companies as a result of being
satisfied by their dividend policies. This is referred to as the ‘clientele effect’. A company with
an established dividend policy is therefore likely to have an established dividend clientele.
The existence of this dividend clientele implies that the share price may change if there is a
change in the dividend policy of the company, as shareholders sell their shares in order to
reinvest in another company with a more satisfactory dividend policy. In a perfect capital
market, the existence of dividend clienteles is irrelevant, since substituting one company for
another will not incur any transaction costs. Since real-world capital markets are not perfect,
however, the existence of dividend clienteles suggests that if DD Co changes its dividend
policy, its share price could be affected.
3. Explain the nature of a scrip (share) dividend and discuss the advantages and
disadvantages to a company of using scrip dividend to reward shareholders. ( 6
marks ) – June 2011
A scrip (or share) dividend is an offer of shares in a company as an alternative to a cash

dividend. It is offered pro rata to existing shareholdings.
From a company point of view, it has the advantage that, if taken up by shareholders, it will
conserve cash, i.e. it will reduce the cash outflow from a company compared to a cash
dividend. This is useful when liquidity is a problem, or when cash is needed to meet capital
investment or other financing needs. Another advantage is that a scrip dividend will lead to a
decrease in gearing, whether on a book value or a market value basis, because of the
increase in issued shares. This decrease in gearing will increase debt capacity.
A disadvantage of a scrip dividend is that in future years, because the number of shares in
issue has increased, the total cash dividend will increase, assuming the dividend per share
is maintained or increased.

CHAPTER 14: COST OF CAPITAL
1.Discuss whether the dividend growth model or capital asset pricing model should
be used to calculate the cost of equity. ( 5 marks )-Dec 2013
The dividend growth model calculates the - apparent cost of equity in the capital market,
provided that the current market price of the share, the current dividend and the future
dividend growth rate are=
-
-
known. While the current market price and the current dividend are
readily available, it is very difficult to find an accurate value for the future dividend growth
-
rate. -
A common approach to finding the future dividend growth rate is to calculate the average
historic dividend growth rate and then to assume that the future dividend growth rate will be
-
- - -
similar. There is no reason why this assumption should be true.
The capital asset pricing model tends to be preferred to the dividend growth model as a way
of calculating the cost of equity as it has a sound theoretical basis, relating the cost of equity
or required return of well-diversified shareholders to the systematic risk they face through
==
owning the shares of a company. However, finding suitable values for the variables used by
the capital asset pricing model (risk-free rate of return, equity beta and equity risk premium)
can be difficult.
-
2.Discuss why market value after-tax WACC is preferred to book value WACC when
making investment decisions. (4 marks) – Dec 2012
Market values of different sources of finance are preferred to their book values when
calculating weighted average cost of capital (WACC) because market values reflect the
current conditions in the capital market. The relative proportions of the different sources of
finance in the capital structure reflect more appropriately their relative importance to a
company if market values are used as weights.
For example, the market value of equity is usually much greater than its book value, so
using book values for weights would seriously underestimate the relative importance of the
cost of equity in the weighted average cost of capital.
If book values are used as weights, the WACC will be lower than if market values were
used, due to the understatement of the contribution of the cost of equity, which is higher than
the cost of capital of other sources of finance.
This can be seen in the case of BKB Co, where the market value after-tax WACC was found
to be 9·4% and the book value after-tax WACC is 8·7% (10% x 40 + 8% x 10 + 6·43% x
20/70).
If book value WACC were used as the discount rate in investment appraisal, investment
projects would be accepted that would be rejected if market value WACC were used. Using
book value WACC as the discount rate will therefore lead to sub-optimal investment
decisions.
As far as the cost of debt is concerned, using book values rather than market values for
weights may make little difference to the WACC, since bonds often trade on the capital
market at or close to their nominal (par) value. In addition, the cost of debt is lower than the
cost of equity and will therefore make a smaller contribution to the WACC. It is still possible,
however, that using book values as weights may under- or over-estimate the contribution of
the cost of debt to the WACC.

3.Discuss how the shareholder of Corhig Co can assess the extent to which they face
the following risk , explaining ,in each case the nature of the risk being assessed .
i) business risk
ii) financial risk
iii) systematic risk
(9 marks) –June 2012
Nature and assessment of business risk

Business risk arises due to the nature of a company’s business operations, which
determines the business sector into which it is classified, and to the way in which a company
conducts its business operations. Business risk is the variability in shareholder returns that
arises as a result of business operations. It can therefore be related to the way in which
profit before interest and tax (PBIT or operating profit) changes as revenue or turnover
changes. This can be assessed from a shareholder perspective by calculating operational
gearing, which essentially looks at the relative proportions of fixed operating costs to
variable operating costs. One measure of operational gearing that can be used is (100 x
contribution/PBIT), although other measures are also used.
Nature and assessment of financial risk

Financial risk arises due to the use of debt as a source of finance, and hence is related to
the capital structure of a company. Financial risk is the variability in shareholder returns that
arises due to the need to pay interest on debt. Financial risk can be assessed from a
shareholder perspective in two ways. Firstly, balance sheet gearing can be calculated. There
are a number of gearing measures that can be used, such as the debt/equity ratio, the debt
ratio and financial gearing, and the calculation can be based on either market values or book
values. Secondly, the interest coverage ratio can be calculated.
Nature and assessment of systematic risk

From a shareholder perspective, systematic risk is the sum of business risk and financial
risk. Systematic risk is the risk that remains after a shareholder has diversified investments
in a portfolio, so that the risk specific to individual companies has been diversified away and
the shareholder is faced with risk relating to the market as a whole. Market risk and
undiversifiable risk are therefore other names for systematic risk. From a shareholder
perspective, the systematic risk of a company can be assessed by the equity beta of the
company. If the company has debt in its capital structure, the systematic risk reflected by the
equity beta will include both business risk and financial risk. If a company is financed entirely
by equity, the systematic risk reflected by the equity beta will be business risk alone, in
which case the equity beta will be the same as the asset beta.
4.Difference between systematic risk and unsystematic risk in relation to portfolio

theory and the capital asset pricing model. ( 6 marks ) – June 2014
Ena .
Portfolio theory suggests that investors can reduce the total risk on their investments by
-
diversifying their portfolio of investments.
Even when a portfolio has been well-diversified over a number of different investments,
there is a limit to the risk-reduction effect so that there is a level of a risk which cannot be
-
diversified away. Systematic risk is an undiversifiable risk as this is = a risk of the financial
system as a whole. Whilst unsystematic risk is a diversifiable risk as it is the element of total
=
risk relates to individual or specific companies rather than to the financial system as a whole.
Portfolio theory is concerned with total risk, which is the sum of systematic risk and
unsystematic risk. The capital asset pricing model assumes that investors hold diversified
=
portfolios, and so is concerned with systematic risk alone.
-

5. The circumstances under which it is appropriate to use the current WACC of Tufa
Co in appraising an investment project. ( 3 marks ) – Sept /Dec 2017
The current WACC of Tufa Co represents the mean return required by the company’s
investors, given the current levels of business risk and financial risk faced by the company.
The current WACC can be used as the discount rate in appraising an investment project of
the company provided that undertaking the investment project does not change the current
levels of business risk and financial risk faced by the company.
The current WACC can therefore be used as the discount rate in appraising an investment
project of Tufa Co in the same business area as current operations, for example, an
expansion of current business, as business risk is likely to be unchanged in these
circumstances. Similarly, the current WACC can be used as the discount rate in appraising
an investment project of Tufa Co if the project is financed in a way that mirrors the current
capital structure of the company, as financial risk is then likely to be unchanged. The
required return of the company’s investors is likely to change if the investment project is
large compared to the size of the company, so the WACC is likely to be an appropriate
discount rate providing the investment is small in size relative to Tufa Co.
6. How to CAPM can be used to calculate a project-specific discount rate . ( 11 marks )

– Dec 2008
The capital asset pricing model (CAPM) can be used to calculate a project-specific discount
rate in circumstances where the business risk of an investment project is different from the
business risk of the existing operations of the investing company.
The first step in using the CAPM to calculate a project-specific discount rate is to find a
proxy company (or companies) that undertake operations whose business risk is similar to
that of the proposed investment.
The equity beta of the proxy company will represent both the business risk and the financial
risk of the proxy company. The effect of the financial risk of the proxy company must be
removed to give a proxy beta representing the business risk alone of the proposed
investment. This beta is called an asset beta and the calculation that removes the effect of
the financial risk of the proxy company is called ‘ungearing’.
The asset beta representing the business risk of a proposed investment must be adjusted to
reflect the financial risk of the investing company, a process called ‘regearing’. This process
produces an equity beta that can be placed in the CAPM in order to calculate a required rate
of return (a cost of equity). This can be used as the project-specific discount rate for the
proposed investment if it is financed entirely by equity. If debt finance forms part of the
financing for the proposed investment, a project-specific weighted average cost of capital
can be calculated.
Limitation of using CAPM in investment appraisal:

The limitations of using the CAPM in investment appraisal are both practical and theoretical
in nature.
From a practical point of view, there are difficulties associated with finding the information
needed. This applies not only to the equity risk premium and the risk-free rate of return, but
also to locating appropriate proxy companies with business operations similar to the
proposed investment project. Most companies have a range of business operations they
undertake and so their equity betas do not reflect only the desired level and type of business
risk.
From a theoretical point of view, the assumptions underlying the CAPM can be criticised as
unrealistic in the real world. For example, the CAPM assumes a perfect capital market, when

in reality capital markets are only semi-strong form efficient at best. The CAPM assumes
that all investors have diversified portfolios, so that rewards are only required for accepting
systematic risk, when in fact this may not be true. There is no practical replacement for the
CAPM at the present time, however.
7.Discuss the limitations of the dividend growth model as a way of valuing the
ordinary shares of a company (4 marks) – March / June 2016
The dividend growth model (DGM) values the ordinary shares of a company as the present
value of its expected future dividends and the model makes the assumption that these future
dividends increase at a constant annual rate.
The main problem with the DGM is that while predictions can be made of future dividends,
future dividends cannot be known with certainty as in real world, dividends do not increase
at a constant annual rate. It is therefore unlikely that future dividends will increase at a
constant annual rate in perpetuity.
The DGM also assumes that the cost of equity is constant. In reality, the cost of equity will
change as economic circumstances change. It is therefore unrealistic to expect that the cost
of equity will remain constant in the future.
8.Weaknesses of the dividend growth model as a way of valuing a company and its
share. ( 5 marks ) – Dec 2011
The weaknesses of the dividend growth model as a way of valuing a company and its
shares are the company must assume that the future dividend growth rate is constant.
Estimating the future dividend growth rate is very difficult in practise and the dividend growth
model is very sensitive to small changes in this key variable. The way to calculate the
estimate future dividend growth rate by using historical dividend growth, but the assumption
that the future will reflect the past is an easy one to challenge.
The dividend growth model also assume that the future cost of equity is constant. The
cost of equity can be calculated using the capital asset pricing model, but this model usually
employs historical information, which may reflect accurately expectation about the future.
The weaknesses of the dividend growth model happen when the company does not pay
the dividend. If dividend are forecast to be paid from a future date, the dividend growth
model can be applied at that point to calculate a share price, which can be discounted to
give the current ex dividend share price. No application of the dividend growth model if no
dividend are expected to be paid.
9. Circumstances under which WACC can be used as a discount rate in investment

appraisal. Briefly indicate alternative approaches that could be adopted when using
the WACC is not appropriate.
(7 marks ) – Dec 2011
The circumstances that weighted average cost of capital (WACC) can be used as a discount
rate in investment appraisal when the business risk and financial risk are the same as those
currently faces by the investing company. If this is not the case, a marginal cost of capital or
a project-specific discount rate must be used to assess the acceptability of an investment
project.
The business risk of an investment project will be the same as business operation. If the
project is an extension of existing business operation, and if it is small in comparison with
current business operation. If this is the case, existing providers of finance will not change

their current required rates of return. If these conditions are not met, a project-specific
discount rate should be calculated.
The financial risk of an investment project is same as the financial risk faced by company if
debt and equity are raised. It may still be appropriate to use the current WACC as a discount
rate even when the incremental finance raised does not preserve the existing capital
structure, providing that the existing capital structure is preserved on an average basis over
time via subsequent finance-raising decisions.
10.How the capital asset pricing model can assist the company in making a better
investment decision with respect to its new product launch. (8 marks) – Sept / Dec
2016
A company can use its weighted average cost of capital (WACC) as the discount rate in
appraising an investment project as long as the project’s business risk and financial risk are
similar to the business and financial risk of existing business operations. Where the business
risk of the investment project differs significantly from the business risk of existing business
operations, a project-specific discount rate is needed.
The capital asset pricing model (CAPM) can provide a project-specific discount rate. The
equity beta of a company whose business operations are similar to those of the investment
project (a proxy company) will reflect the systematic business risk of the project. If the proxy
company is geared, the proxy equity beta will additionally reflect the systematic financial risk
of the proxy company.
The proxy equity beta is ungeared to remove the effect of the proxy company’s systematic
financial risk to give an asset beta which solely reflects the business risk of the investment
project. This asset beta is regeared to give an equity beta which reflects the systematic
financial risk of the investing company.
The regeared equity beta can then be inserted into the CAPM formula to provide a project-
specific cost of equity. If this cost of capital is used as the discount rate for the investment
project, it will indicate the minimum return required to compensate shareholders for the
systematic risk of the project. The project-specific cost of equity can also be included in a
project-specific WACC. Using the project-specific WACC in appraising an investment project
will lead to a better investment decision than using the current WACC as the discount rate,
as the current WACC does not reflect the risk of the investment project.

CHAPTER 15: GEARING AND CAPITAL STRUCTURE
1.Discuss the usefulness of debt/equity ratio in assessing the financial risk of GWW
Co. ( 7 marks ) –Dec 2012
Financial risk relates to the variability in shareholder returns (profit after tax or earnings) that
is caused by the use of debt in a company’s capital structure. The debt/equity ratio is
therefore useful in assessing financial risk as it measures the relative proportion of debt to
equity. Financial risk will increase as the debt/equity ratio increases, whether the ratio uses a
book value basis or a market value basis.
In assessing financial risk, however, the debt/equity ratio, like other accounting ratios, needs
a basis for comparison. It is often said that a ratio in isolation has no meaning. In assessing
financial risk, therefore, the trend over time in a company’s debt/equity ratio can be
considered, a rising trend indicating increasing financial risk. A comparison can also be
made with the debt/equity ratios of similar companies, or with sector average debt/equity
ratio, in order to assess relative financial risk.
Since financial risk relates to the variability in shareholder returns in the income statement,
another commonly used way of assessing financial risk is the interest coverage ratio,
sometimes calculated as interest gearing. This can be a more sensitive measure of financial
risk than the debt/equity ratio, in that it can indicate when a company is experiencing
increasing difficulty in meeting its interest payments. It should be noted that difficulty in
meeting interest payments can be a problem even when the debt/equity ratio is low.
2. Discuss the reasons why small and medium sized entities ( SMEs) might
experience less conflict between the objectives of shareholder and directors than
large listed companies. (4 marks) –June 2012
Conflict between the objectives of shareholders and directors in a listed company is

associated with the agency problem, which has three main causes. First, the objectives of
shareholders and directors may be different.
Second, there is asymmetry of information, so that shareholders have access to less

information about the company than directors, making it hard for shareholders to monitor the
actions and decisions of directors.
Third, there is a separation between ownership and control, as shareholders and directors
are different people. One reason why small and medium-sized entities (SMEs) might
experience less conflict between shareholders and directors than larger listed companies is
that in many cases shareholders are not different from directors, for example in a family-
owned company.
Where that is the case, there is no separation between ownership and control, there is no
difference between the objectives of shareholders and directors, and there is no asymmetry
of information. Conflict between the objectives of shareholders and directors will therefore
not arise. Another reason why there may be less conflict between the objectives of
shareholders and directors in SMEs than in larger listed companies is that the shares of
SMEs are often owned by a small number of shareholders, who may be in regular contact
with the company and its directors. In these circumstances, the possibility of conflict is very
much reduced

3.Discuss the connection between the relative cost of sources of finance and the
creditor hierarchy (3 marks) – March / June 2016
The creditor hierarchy refers to the order in which financial claims against a company are
settled when the company is liquidated. The hierarchy, in order of decreasing priority, is
secured creditors, unsecured creditors, preference shareholders and ordinary shareholders.
The risk of not receiving any cash in a liquidation increases as priority decreases. Secured
creditors face the lowest risk as providers of finance and ordinary shareholders face the
highest risk.
The return required by a provider of finance is related to the level of risk. Secured creditors
therefore have the lowest required rate of return and ordinary shareholders have the highest
required rate of return. The cost of debt should be less than the cost of preference shares,
which should be less than the cost of equity.

CHAPTER 16: CAPITAL STRUCTURE
1.Discuss whether changing the capital structure of a company can lead to a

reduction in its cost of capital and hence to increase in the value of company. ( 8
marks )- Dec 2013
The value of a company can be expressed as the present value of its future cash flows,
discounted at its weighted average cost of capital (WACC). The value of a company can
therefore theoretically be maximised by minimising its WACC. If the WACC depends on the
capital structure of a company, i.e. on the balance between debt and equity, then the
minimum WACC will arise when the capital structure is optimal.
The idea of an optimal capital structure has been debated for many years. The traditional
view of capital structure suggests that the WACC decreases as debt is introduced at low
levels of gearing, before reaching a minimum and then increasing as the cost of equity
responds to increasing financial risk.
Miller and Modigliani originally argued that the WACC is independent of a company’s capital
structure, depending only on its business risk rather than on its financial risk. This
suggestion that it is not possible to minimise the WACC, and hence that it is not possible to
maximise the value of a company by selecting a particular capital structure, depends on the
assumption of a perfect capital market with no corporate taxation.
However, real world capital markets are not perfect and companies pay taxes on profit.
Since interest is a tax-allowable deduction in calculating taxable profit, debt is a tax-efficient
source of finance and replacing equity with debt will decrease the WACC of a company. In
the real world, therefore, increasing gearing will decrease the WACC of a company and
hence increase its value.
At high levels of gearing, the WACC of a company will increase due, for example, to
increasing bankruptcy risk. Therefore, it can be argued that use of debt in a company’s
capital structure can reduce its WACC and increase its value, provided that gearing is kept
to an acceptable level.
2. Discuss the relationship between capital structure and weighted average cost of
capital, and comment on the suggestion that debt could be used to finance a cash
offer for NGN. ( 9 marks ) –June 2009
Equity is riskier than debt and so equity is more expensive than debt. This does not depend
on the tax efficiency of debt, since we can assume that no taxes exist.
The traditional view of capital structure assumes a non-linear relationship between the cost
of equity and financial risk. As a company gears up, there is initially very little increase in the
cost of equity and the WACC decreases because the cost of debt is less than the cost of
equity. A point is reached, however, where the cost of equity rises at a rate that exceeds the
reduction effect of cheaper debt and the WACC starts to increase. In the traditional view,
therefore, a minimum WACC exists and, as a result, a maximum value of the company
arises.
Modigliani and Miller assumed a perfect capital market and a linear relationship between the
cost of equity and financial risk. They argued that, as a company geared up, the cost of
equity increased at a rate that exactly cancelled out the reduction effect of cheaper debt.
WACC was therefore constant at all levels of gearing and no optimal capital structure, where
the value of the company was at a maximum, could be found.

It was argued that the no-tax assumption made by Modigliani and Miller was unrealistic,
since in the real world interest payments were an allowable expense in calculating taxable
profit and so the effective cost of debt was reduced by its tax efficiency. They revised their
model to include this tax effect and showed that, as a result, the WACC decreased in a
linear fashion as a company geared up. The value of the company increased by the value of
the ‘tax shield’ and an optimal capital structure would result by gearing up as much as
possible.
It was pointed out that market imperfections associated with high levels of gearing, such as
bankruptcy risk and agency costs, would limit the extent to which a company could gear up.
In practice, therefore, it appears that companies can reduce their WACC by increasing
gearing, while avoiding the financial distress that can arise at high levels of gearing.
It has further been suggested that companies choose the source of finance which, for one
reason or another, is easiest for them to access (pecking order theory). This results in an
initial preference for retained earnings, followed by a preference for debt before turning to
equity. The view suggests that companies may not in practice seek to minimise their WACC
(and consequently maximise company value and shareholder wealth).
Turning to the suggestion that debt could be used to finance a cash bid for NGN, the current
and post acquisition capital structures and their relative gearing levels should be considered,
as well as the amount of debt finance that would be needed. KFP Co would need to consider
how it could service this dangerously high level of gearing and deal with the significant risk
of bankruptcy that it might create. It would also need to consider whether the benefits arising
from the acquisition of NGN would compensate for the significant increase in financial risk
and bankruptcy risk resulting from using debt finance.
3.Discuss the director’s view that issuing traded bonds will decrease the weighted
average cost of capital thus increase value of the company.( 8 marks ) – June 2011
Marginal and average cost of debt

As for decreasing the WACC by issuing traded bonds, if the marginal cost of capital, in this
case the cost of debt of the new bond issue, is less than the WACC, it would seem logical to
expect the WACC to decrease. However, increasing gearing will increase financial risk and
may lead to an increase in the cost of equity, offsetting the effect of the cheaper debt.
Traditional view of capital structure

In the traditional view of capital structure, there is a non-linear relationship between the cost
of equity and financial risk, as measured by gearing. Equity investors are indifferent to the
addition of small amounts of debt, so as a company gears up by replacing expensive equity
with cheaper debt, the WACC initially decreases.
Debt is cheaper than equity because of the relative positions of the two sources of finance in
the creditor hierarchy (ignores taxation). As equity investors start to respond to increasing
financial risk, however, the cost of equity begins to increase until a point is reached where
WACC ceases to fall. This corresponds to an optimal capital structure, since at this point
WACC is at a minimum and hence the market value of the company is at a maximum. After
this point, the WACC starts to increase as the company continues to gear up, rising more
quickly at very high levels of gearing due to the appearance of bankruptcy risk.
Miller and Modigliani

Miller and Modigliani showed that in a perfect capital market without corporate taxation, the
replacement of expensive equity with cheaper debt did not lead to a decrease in the WACC,
since the effect of adding in cheaper debt was exactly offset by the increase in the cost of
equity. This meant that the market value of the company was only depended only on its
business operations (business risk).

In their second paper on capital structure Miller and Modigliani showed that, if taxation were
allowed (after-tax cost of debt was considered), replacing equity with debt led to a linear
decrease in the WACC, because of the tax shield on profits gained by interest payments
being an allowable deduction in calculating tax liability. Under this contribution to capital
structure theory, gearing up as much as possible would maximise the market value of the
company.
Market imperfections view

In reality, it was noted that companies do not gear up as much as possible because of the
dangers of high gearing. Further market imperfections, relative to the idea of a perfect
capital market in Miller and Modigliani’s first paper on capital structure, included bankruptcy
risk and the costs of financial distress at high levels of gearing. These reduced and finally
reversed the tax shield effect noted by Miller and Modigliani, resulting in an optimal capital
structure at the point where the WACC was at its lowest and the value of the company was
at its highest.
Pecking order theory

In practice it has been noticed that companies do not appear to base their financing
decisions on the objective of achieving an optimal capital structure, but rather have a
preference for sources of finance in the order of retained earnings, bank loans, ordinary
debt, convertible debt and equity. A number of reasons have been suggested for this
‘pecking order’.


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FM Compilation Theory PYQs (December 2007 – M/J 2019)

CHAPTER 1 : FINANCIAL MANAGEMENT AND FINANCIAL OBJECTIVES

1. Discuss four ways to encourage managers to achieve stakeholder objectives. (8

Share option schemes

Corporate governance codes of best practice

Stock exchange listing regulations

Prepared by: FM-E (July - December 2019)

i) The nature of the agency problem

Shareholder wealth increases through payment of dividends and through appreciation of

Prepared by: FM-E (July - December 2019)

CHAPTER 3: FINANCIAL MARKETS, MONEY MARKETS AND INSTITUTION

Prepared by: FM-E (July - December 2019)

CHAPTER 4: WORKING CAPITAL

3. Discuss whether profitability or liquidity is primary objective of working capital

Prepared by: FM-E (July - December 2019)

4. Evaluate whether Crago can be considered to be overtrading and discuss how

Rapid increase in sales revenue

Prepared by: FM-E (July - December 2019)

CHAPTER 5: MANAGING WORKING CAPITAL

Invoice discounting refers to the purchase of selected invoices by a financial company at a

2. Key elements of a trade receivables management policy. (7 marks) – June 2013

Prepared by: FM-E (July - December 2019)

4. Discuss ways in which a company could improve the management of domestic

Reducing bad debts

Reduction of average accounts receivable period

Prepared by: FM-E (July - December 2019)

6. Briefly discuss how the creditworthiness of potential customers can be assessed.

The creditworthiness of potential customers can be assessed from a range of different

Prepared by: FM-E (July - December 2019)

CHAPTER 6: WORKING CAPITAL FINANCE

2. Discuss THREE factors which determine the level of a company’s investment in

Cash operating cycle

The transactions need for cash:

The precautionary need for cash:

Prepared by: FM-E (July - December 2019)

The speculative need for cash:

The availability of finance:

i) working capital investment

Prepared by: FM-E (July - December 2019)

Working capital policy

Nature of business operations

Prepared by: FM-E (July - December 2019)

CHAPTER 7: INVESTMENT DECISION

Identifying investment opportunities

Screening investment proposals

Analysing and evaluating investment proposals

Approving investment proposals

Implementing, monitoring and reviewing investments

Prepared by: FM-E (July - December 2019)

CHAPTER 8: INVESTMENT APPRAISAL USING DCF METHOD

NPV and shareholder wealth

Changes in cost of capital

Asset replacement decisions (Chapter 11)

Multiple internal rates of return (Chapter 8)

Prepared by: FM-E (July - December 2019)

Prepared by: FM-E (July - December 2019)

CHAPTER 9: ALLOWING FOR INFLATION AND TAXATION

(1 + real discount rate) x (1 + inflation rate) = (1 + nominal discount rate)

Prepared by: FM-E (July - December 2019)

CHAPTER 10: PROJECT APPRAISAL AND RISK

Prepared by: FM-E (July - December 2019)

3. Critically discuss the use of probability analysis in incorporating risk into

4.Methods of adjusting for risk and uncertainty in investment appraisals. (8 marks) –

(ii) Adjusted payback