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Paper F9
Financial Management
This question paper must not be removed from the examination hall.
Section A – ALL 15 questions are compulsory and MUST be attempted
A. 2 only
B. 1 & 3 only
C. 2 & 3 only
D. 1, 2 & 3
What would be the effect on NPV & the IRR of a decrease in the cost of capital?
NPV IRR
A Increase Decrease
B Increase No change
C Decrease No change
D Decrease Decrease
3. A ltd is considering undertaking a project that would yield annual profits (after depreciation) of
$65000 for 5 years. The initial outlay of the project would be $780,000 and the project’s assets have
a residual value of $70000 at the end of the project.
What would be the ARR of this project (through average investment method)?
A. 8.3%
B. 15.3%
C. 7.6%
D. 6.5%
4. Which of the following would be implied by a decrease in a company’s operating gearing ratio? The
company
A. Is less profitable
B. Is more risky
C. Has a lower proportion of costs that are variable
D. Has profits which are less sensitive to changes in sales volume
5. James is considering investing in the textile industry of a country Y. The risk-free rate and return on
market in country Y are 8% and 15% respectively. James has a debt/equity of 140%.
Jason a 100% equity financed company is also in the textile industry of country Y and it has a beta of
1.20. Both companies are taxed at 30%.
What is the cost of equity for James?
A. 8%
B. 15%
C. 24.6%
D. 27.6%
6. Asset-based business valuation using net realizable values are useful in which of the following
situations?
A. When the company is being bought for the earnings/cash flow that all of its assets can produce
in the future
B. For asset stripping
C. To identify a maximum price in a takeover
D. When the company has a highly-skilled workforce
11. A company sells inventory at credit to a customer at a selling price which is below the cost of the
inventory items.
How will this transaction affect the current ratio & the quick ratio immediately after the transaction?
A. Increase Increase
B. Decrease Increase
C. Decrease No change
D. Increase Decrease
12. XYZ Company announced its intention to make a right issue of one share at $1.45 for every four
existing shares. After the announcement of the issue the share price fell by 40c to $2.20. The price
per share just prior to the right issue is $2.45 ex-dividend.
13. What is the difference between the calculation of after cost of debt and yield to maturity?
A. Time to redemption
B. Tax savings on interest
C. Redemption value
D. Market value
14. In the context of managing performance in “not for profit” organizations, which of the following
definitions is incorrect?
A. Value for money means providing a service in a way which is economical, efficient and effective
B. Economy means doing things cheaply: not spending $2 when the same thing can be bought for
$1
C. Efficiency means doing things quickly: minimizing the amount of time that is spent on a given
activity
D. Effectiveness means doing the right things: spending funds so as to achieve the organizations
objectives
15. A new project being considered by Bond Co would require 1,500 hours of skilled labour. The current
workforce is already fully employed but more workers can be hired in at a cost of $18 per hour. The
current workers are paid $13 per hour on a project that earns a contribution of $8 per hour.
The 14% loan notes are redeemable at par in five years’ time. They have a current ex-interest market
price of $110 per $100 loan note. MA Co pays tax on profits at an annual rate of 30%. The market price
of the company’s ordinary share is currently $3.76. AM Co equity beta is estimated to be 1.2. The
systematic risk of debt may be assumed to be zero. The risk free rate is 7% and the market return
13.5%.
The estimated equity beta of the main competitor in the same industry as the new venture is 1.8 and the
competitor’s capital gearing is 60% equity and 40% debt by market values.
Two of the employees of MA Co, John and Elisa are discussing the advantages of CAPM, John said that it
only considers the systematic risk and assumes that investors have a undiversified portfolio whereas Elisa
said that it is a better model to calculate the cost of equity than the dividend growth model and take into
account a company’s level of systematic risk.
A. 2 & 4 only
B. 2 & 3 only
C. 1, 2 & 4 only
D. 3 & 4 only
Recently, Giga Tech’s board of directors has become concerned with the firm’s capital budgeting
decisions and has asked management to provide a detailed explanation of the capital budgeting process.
After reviewing the report from management, the board makes the following comments in a memo:
• We are making appropriate investment decisions since the discount rate used to evaluate all potential
projects is the firm’s current weighted average cost of capital.
• Reasons of capital rationing can be soft and hard capital rationing
• Inability of management to raise additional finance in market is an internal capital rationing reason.
The company finance director has also valued a project with ARR of 12% whereas the companies
targeted ARR is 15%. His main concern is whether the project should be accepted or not?
21. Determine whether board of director’s memo is correct with regard to its statements about Giga
Tech’s capital rationing system and its method of projecting project cash flows. Identify the correct
statement
A. Statement 2 only
B. Statement 2 and 3
C. Statement 3 only
D. Neither 2 nor 3
22. Which of the following would best correct Giga Tech’s discount rate problem described in the board
of director’s memo?
A. Use other methods than NPV which are independent of change in cost of capital
B. Use a beta specific to each potential project to determine the appropriate discount rate
C. Use the cost of the firm’s equity capital to discount the cash flows of all potential projects.
D. Use the cost of the firm’s debt capital to discount the cash flows of all potential projects.
23. The decision rule to the ARR of 12% the company should?
A. Undertake the project
B. Reject the project
C. Do nothing
D. ARR is superior than IRR
Statement 1: Profitability Index is a preferred method than NPV in case of divisible projects because
it considers strategic importance of projects
25. Which of the following method is preferred in case if all projects are strategically important, divisible
and company is facing hard capital rationing?
A. NPV
B. Equivalent Annual Cost
C. Profitability Index
The following scenario relates to questions 26 TO 30
TLQ Co, whose home currency is the dollar, trades regularly with customers in a number of different
countries. The company expects to receive €1,200,000 in six months’ time from a foreign customer.
26. Calculate the loss or gain compared to its current dollar value which TLQ Co will incur by
taking out a forward exchange contract
A. $3,521
B. $3,544
C. $1,497
D. $5,568
27. If the interest rate in the home country of TLQ Co is 4% per year, calculate the annual
interest rate in the foreign customer’s country implied by the spot exchange rate and the
twelve-month forward exchange rate.
A. 5.8%
B. 1.5%
C. 7.4%
D. 6.6%
28. Which of the following is not the internal hedging method of foreign currency risk.
A. Matching and Invoice in Home Currency
B. Money market hedging
C. Netting and Do Nothing
D. Creating Assets and Liabilities in foreign.
A. 1, 3 & 4 only
B. 2, 4 & 5 only
C. 2 & 3 only
D. 1 & 5 only
30. What is true for Currency swap transaction?
1. Initial value of swap contract is always positive for one party and negative for other party
2. The counterparties exchange notional principals in the two currencies
3. Swap contract have No default risk like forward contract.
4. Currency swaps like future contracts are traded on exchanges.
A. 2 only
B. 1, 3 & 4 only
C. 4 only
D. 2, 3 & 4 only
Section C – BOTH questions are compulsory and MUST be attempted
31. The finance director of Harvey Co is having some working capital financing problem. Harvey Co has
revenue of $30 million per year, of which 15% are cash sales. The terms of trade states that the
standard days are 45. Approximately 1% of credit sales are bad debts currently.
Trade receivables currently stand at $4.45 million and Harvey Co has a cost of short-term finance of
7% per year. The finance director is considering a proposal from a factoring company, Zof Co, which
is offering factoring with or without recourse or invoice discounting services.
Zof Co believes that it can use its expertise to reduce average trade receivables days to 30 days,
while bad debts reduced to 0.60% of sales and reducing administration costs by $40,000 per year. A
condition of the factoring agreement is that the company would also advance Harvey Co 80% of the
value of invoices raised at an interest rate of 8% per year. Zof Co would charge an annual fee of
1.25% of credit sales without recourse and 0·75% of credit sales with recourse. Assume that there
are 365 days in each year.
Required:
a) Advise whether the factor’s offer is financially acceptable to Harvey Co, both by
• With recourse arrangement
• Without recourse arrangement
(10 Marks)
(Total = 20 marks)
32. Shantaram Co is concerned about its current level of debt finance. It plans to make a rights issue
and to use the funds raised to pay off some of its debt and investment in business. The rights issue
will beat a 15% discount to its current ex-dividend share price of $8·90 per share and Shantaram
Co plans to raise $150 million, out of this Shantaram wants to invest 20 million in new project which
will yield 18% before tax profit on it. Issuance cost on right issue is 1 million. Shantaram Co believes
that paying off some of its debt a n d i n v e s t m e n t i n n e w p r o j e c t will not affect its
price/earnings ratio, which is expected to remain constant.
Company is ready to buy bonds at 12.5% premium to par. It is expected that bond holder will agree
to it.
Required:
(a) Calculate the theoretical ex rights price per share of Shantaram Co following the rights
issue.
(4 marks)
(b) Calculate and discuss whether shareholders will financially accept the proposal of using
the cash raised via the rights issue to redeem bonds and investment in new project.
Comment in your answer on the belief Whether or not the current price/earnings ratio
will remain constant.
(12 marks)
(c) Briefly discuss the advantages of Right issue to both company and existing shareholders?
(4 marks)
(Total: 20 marks)