Multiple Choice Questions



ACCA F9

Financial Management

Revision Class 4

Session 4

Patrick Lui

hklui2007@.hk

|Revision 5 |

Revision 5 – Cost of Capital

Topic List

|1. |Cost of Capital |Exam Question Reference |

| |a. Meaning | | |

|2. |Estimating the Cost of Equity | | |

| |a. Dividend valuation model (DVM) | | |

| |Calculation |Pilot |Q1a |

| | |Dec 09 |Q2c |

| | |Jun 11 |Q2a |

| | |Jun 13 |Q2a |

| | |Dec 13 |Q2a |

| |Weaknesses | | |

| |b. Estimating the growth rate | | |

| |Simple average | | |

| |Geometric growth |Dec 12 |Q4a(iv) |

| | |Jun 13 |Q2a |

| | |Dec 13 |Q2a |

| |Earnings retention model |Dec 12 |Q4a(iv) |

| |c. CAPM | | |

| |Calculation |Dec 08 |Q1c |

| | |Jun 09 |Q1a |

| | |Dec 09 |Q2c |

| | |Jun 10 |Q4a(i) |

| | |Jun 12 |Q4b |

| | |Dec 12 |Q3a |

| | |Jun 14 |Q3a |

| |Systematic risk and unsystematic risk |Jun 12 |Q4d(iii) |

| | |Jun 13 |Q2b |

| | |Jun 14 |Q3c |

| |Assumptions | | |

| |Limitations |Dec 08 |Q3c |

| |d. Comparison between DVM and CAPM |Jun 08 |Q1c |

| | |Dec 13 |Q2b |

|3. |Cost of Debt and Other Capital Instruments | | |

| |a. Irredeemable debt | | |

| |b. Redeemable debt (e.g. bonds) |Jun 09 |Q1a |

| | |Dec 09 |Q2a |

| | |Jun 10 |Q2a |

| | |Dec 10 |Q4b |

| | |Jun 11 |Q2a |

| | |Dec 11 |Q3c |

| | |Jun 13 |Q2a |

| | |Dec 13 |Q2c |

| | |Jun 14 |Q3a |

| |c. Convertible debt |Dec 07 |Q1b |

| | |Dec 12 |Q3a |

| |d. Preference shares |Pilot |Q1a |

| | |Dec 10 |Q4c |

| | |Dec 12 |Q3a |

| | |Jun 13 |Q2a |

| |e. Bank debt |Jun 12 |Q4c |

| | |Jun 13 |Q2a |

| |f. Comparison between cost of equity and cost of debt |Jun 13 |Q2c |

|4. |WACC | | |

| |a. Computation by book value | | |

| |b. Computation by market value |Pilot |Q1a |

| | |Jun 08 |Q1a |

| | |Dec 08 |Q3a |

| | |Jun 09 |Q1a |

| | |Dec 09 |Q2c |

| | |Jun 10 |Q2b |

| | |Dec 10 |Q4c |

| | |Jun 11 |Q2a |

| | |Dec 11 |Q3c |

| | |Jun 12 |Q4c |

| | |Dec 12 |Q3a,b |

| | |Jun 13 |Q2a |

| | |Dec 13 |Q2c |

| | |Jun 14 |Q3a |

| |c. When is suitable for using in investment appraisal |Jun 08 |Q1b |

| | |Dec 11 |Q3d |

|5. |Marginal Cost of Capital | | |

| | | | |

|6. |Traditional View of Capital Structure | | |

| |a. Concept |Pilot |Q1b |

| | |Jun 09 |Q1c |

| | |Jun 11 |Q2c |

| | |Dec 13 |Q2e |

| |b. Assumptions | | |

| | | | |

|7. |M&M Views on Capital Structure | | |

| |a. Without tax (1958) |Pilot |Q1b |

| | |Jun 09 |Q1c |

| | |Jun 11 |Q2c |

| | |Dec 13 |Q2e |

| |b. With tax (1963) |Pilot |Q1b |

| | |Jun 09 |Q1c |

| | |Jun 11 |Q2c |

| | |Dec 13 |Q2e |

| |c. Their assumptions | | |

|8. |Market Imperfections |Jun 09 |Q1c |

| | |Jun 11 |Q2c |

| | |Dec 13 |Q2e |

| | | | |

|9. |Pecking Order Theory |Jun 09 |Q1c |

| | |Jun 11 |Q2c |

|10. |CAPM and M&M Combined – Project-specific Discount Rate | | |

| |a. When to use? | | |

| |b. Steps for calculating a project-specific discount rate |Dec 08 |Q3c |

| | |Jun 10 |Q3c(iii) |

| | |Dec 10 |Q1c |

| | |Jun 13 |Q2b |

| | |Dec 13 |Q2d |

| | |Jun 14 |Q3b |

Chapter 15 The Cost of Capital

I. The Cost of Capital

1. Consider the following two statements concerning investor attitudes towards risk:

1. A risk-averse investor will only be prepared to invest in a project with the prospect of high returns if there are no risks involved.

2. A risk-seeking investor will readily invest in a project with prospects of high returns, even if it means carrying substantially high risk.

Which one of the following combinations relating to the above statements is correct?

| |Statement 1 |Statement 2 |

|A |True |True |

|B |True |False |

|C |False |True |

|D |False |False |

II. Cost of Equity – Dividend Valuation Model

2. Lydford Electronics plc has issued nominal share capital of $10 million, made up of $0·25 ordinary shares, and a market capitalisation of $20 million. The company expects post-tax profits for the forthcoming year to be $8 million and wishes to maintain a constant dividend payout ratio of 25%. Dividends are expected to increase by 3% per year for the foreseeable future.

What is the expected rate of return from the ordinary shares?

A 7%

B 13%

C 17%

D 23%

3. The current market value of shares in Segontium Co is $2·50 and the most recent dividend was $0·20 per share. The annual growth rate in dividends is expected to be 5%.

What is the cost of the company’s equity share capital?

A 3·4%

B 7·6%

C 13·0%

D 13·4%

4. Teal plc has a market capitalisation of $30 million and forecast post-tax profits for the forthcoming year of $10 million. The company has an issued share capital of $1 million, which is made up of $0·50 ordinary shares. The policy of Teal plc is to maintain a constant dividend cover of 2·5 times. Dividends are expected to increase by 5% per annum for the foreseeable future.

Which of the following is the expected rate of return from the ordinary shares?

A 8·3%

B 18·3%

C 21·7%

D 31·7%.

5. Gypsum plc has 20 million $0·25 ordinary shares in issue. The company has a market capitalisation of $60 million and has reported post-tax profits of $15 million for the year that has just ended. The company expects profits to rise by 20% and the dividend payout ratio is expected to be 30% in the forthcoming year. The company is committed to increasing the dividend by 4% per annum for the foreseeable future.

Which one of the following is the expected rate of return from the ordinary shares?

A 4·1%

B 11·5%

C 13·0%

D 15·1%

6. Cygnus plc has a dividend cover ratio of 4·0 times and dividends are expected to increase by 4% per year for the foreseeable future. The company has one million $1 ordinary shares in issue and the market capitalisation (value) of the company is $50 million. After-tax profits for next year are expected to be $20 million.

What is the expected rate of return from the ordinary shares?

A 6·0%

B 10·0%

C 14·0%

D 25·0%

7. Linacre plc has twenty million $0·50 ordinary shares in issue and the company has a market capitalisation (value) of $60 million. The company has a constant dividend cover ratio of 2·0 times and has a price earnings ratio of 10 times. Dividends per share and profits are expected to remain constant for the foreseeable future.

What is the expected rate of return from the ordinary shares?

A 0·8%

B 5·0%

C 20·0%

D 30·0%

8. Cassini plc has 40 million $0·50 ordinary shares in issue and has a market capitalisation of $160 million after announcing the following information concerning profits, dividends and projected growth. The company has reported post-tax profits of $20 million for the year that has just ended and expects profits to rise by 40% in the forthcoming year. The dividend cover ratio will be 2·5 times in the forthcoming year. After this, the company wishes to increase the dividend by a compound rate of 6% per year for the foreseeable future.

What is the expected rate of return from an ordinary share?

A 16·07%

B 11·00%

C 13·00%

D 19·50%

9. IPA Co is about to pay a $0.50 dividend on each ordinary share. Its earnings per share was $1.50. Net assets per share is $6. Current share price is $4.50 per share.

What is the cost of equity?

A 31%

B 30%

C 22%

D 21%

III. CAPM

A. Systematic risk and unsystematic risk

10. Risk that cannot be diversified away can be describe as

A Systematic risk

B Financial risk

C Unsystematic risk

D Business risk

11. Which of the following statements about systematic and unsystematic risk is correct?

A Neither systematic nor unsystematic risk can be diversified away

B Only systematic risk can be diversified away

C Only unsystematic risk can be diversified away

D Both systematic and unsystematic risk can be diversified away.

12. Which of the following best describes systematic risk?

A The chance that automated processes may fail

B The risk associated with investing in equity

C The diversifiable risk associated with investing in equity

D The residual risk associated with investing in a well-diversified portfolio.

13. Beta factors (β) measure the systematic risk of a portfolio relative to the market portfolio.

Which of the following statements is true?

(1) If β < 1 the security is less sensitive to systematic risk than the market average

(2) If β > 1 the security is less sensitive to systematic risk than the market average

(3) If β = 1 the security's exposure to systematic risk exactly matches the market average

(4) If β = 0 the security is risk free

A (1) and (4) only

B (2) and (3) only

C (1), (3) and (4) only

D (2), (3) and (4) only

14. Consider the following statements:

1. Investors can only expect to receive a return for incurring unsystematic risk.

2. Systematic risk can be eliminated by holding a well-diversified portfolio of shares.

Which one of the following combinations relating to the above statements is correct?

| |Statement 1 |Statement 2 |

|A |True |True |

|B |True |False |

|C |False |True |

|D |False |False |

15. A share that has a beta of 1·0 will have which one of the following properties?

A An expected return that is equal to the risk-free rate

B An expected return that is equal to the expected returns from the market

C An expected return that is above the expected returns from the market

D No non-diversifiable risk.

16. The following two statements concern the propositions which underpin the capital asset pricing model (CAPM).

1. Investors in shares require a return in excess of the risk-free rate to compensate for systematic risk.

2. Investors will require higher returns from shares in companies where the level of systematic risk is higher.

Which one of the following combinations (true/false) is correct?

| |Statement 1 |Statement 2 |

|A |True |True |

|B |True |False |

|C |False |True |

|D |False |False |

17. Consider the following statements:

1. The amount of systematic risk varies between different forms of investment

2. Systematic risk can be diversified away by holding a suitably wide portfolio of investments

Which one of the following combinations (true/false) relating to the above statements is correct?

| |Statement 1 |Statement 2 |

|A |True |True |

|B |True |False |

|C |False |True |

|D |False |False |

18. Four companies are identical in all respects, except for their capital structures, which are as follows:

| |A plc |B plc |C plc |D plc |

| |% |% |% |% |

|Equity as a proportion of total market capitalization |70 |20 |65 |40 |

|Debt as a proportion of total market capitalization |30 |80 |35 |60 |

The equity beta of A plc is 0.89 and the equity beta of D is 1.22.

Within which ranges will the equity betas of B plc and C plc lie?

A The beta of B plc and the beta of C plc are both higher than 1.22

B The beta of B plc is below 0.89 and the beta of C plc is in the range of 0.89 to 1.22

C The beta of B plc is above 1.22 and the beta of C plc is in the range of 0.89 to 1.22

D The beta of B plc is in the range 0.89 to 1.22 and the beta of C plc is higher than 1.22

19. Which of the following assumptions is not required when using the capital asset pricing model to estimate the cost of equity for project appraisal?

A Efficient capital markets

B Well diversified investors

C Future periods are consistent with the present

D Companies are well diversified

|Question 1 – Business risk, financial risk and systematic risk |

|Discuss how the shareholders of Corhig Co can assess the extent to which they face the following risks, explaining in each case the |

|nature of the risk being assessed: |

|(a) Business risk; |

|(b) Financial risk; |

|(c) Systematic risk. (9 marks) |

|(ACCA F9 Financial Management June 2012 Q4(d)) |

B. Calculation of expected rate of return

20. Shares in Alborz Co have an expected rate of return of 9% and a beta of 0·8. Shares in Ural Co have a beta of 1·2. The expected market rate of return is 10%.

Using the Capital Asset Pricing Model (CAPM), what is the expected rate of return for shareholders in Ural Co?

A 8·7%

B 11·0%

C 13·0%

D 13·5%

21. The shares of Danae plc have a beta of 0·5 and the shares of Alcmene plc have a beta of 2·0. Investors have an expected rate of return of 4% from shares in Danae plc and the expected returns to the market are 6%.

Using the Capital Asset Pricing Model, what will be the expected rate of return for investors in Alcmene plc?

A 8%

B 10%

C 12%

D 16%.

22. Investors have an expected rate of return of 8% from ordinary shares in Algol plc, which have a beta of 1·2. The expected returns to the market are 7%.

What will be the expected rate of return from ordinary shares in Rigel plc, which have a beta of 1.8?

A 9·0%

B 10·5%

C 11·0%

D 12·6%

23. The shares of Lincoln plc have a beta of 0·4 and an expected rate of return of 5%. The expected market rate of return is 8%. The shares of Wadham plc have a beta of 1·5.

Using the Capital Asset Pricing Model, what will be the expected rate of return for investors in Wadham plc?

A 10·5%

B 11·3%

C 15·0%

D 18·8%

24. A share in MS Co has an equity beta of 1.3. MS Co’s debt beta is 0.1. It has a gearing ratio of 20% (debt:equity). The market premium is 8% and the risk free rate is 3%. MS Co pays 30% corporation tax.

What is the cost of equity for MS Co?

A 8.4%

B 12.2%

C 13.4%

D 9.5%

25. A security’s required return can be predicted using the CAPM using the formula:

Rj = Rf + β × (Rm – Rf)

Security X has a beta value of 1.6 and provides a return of 12.0%

Security Y has a beta value of 0.9 and provides a return of 13.0%

Security Z has a beta value of 1.2 and provides a return of 13.2%

Security Z is correctly priced.

The risk free return is 6%.

What does this information indicate about the pricing of securities X, Y?

| |Security X |Security Y |

|A |Underpriced |Overpriced |

|B |Correctly priced |Underpriced |

|C |Underpriced |Correctly priced |

|D |Overpriced |Underpriced |

IV. Cost of debt

26. Mallard plc issues loan capital with a par value of £100 million at a price of £90 per £100 nominal value. The annual interest rate is 10% of the nominal capital. The loan capital will be redeemed in two years’ time at its nominal value. The effective rate of corporation tax for the business is 30% and tax relief arises in the same year as the interest payment.

What is the net cost of the loan capital (to the nearest per cent) to the business?

A 17%

B 10%

C 13%

D 16%

27. Ishim Co has issued $50 million of 6% convertible bonds at $105 per $100 nominal value. The bonds are convertible in three years’ time into ordinary shares of the company. The conversion rate will be 20 shares for every $100 of convertible bonds. The ordinary shares are currently trading at $4·50 per share.

What is the conversion premium (to the nearest cent)?

A 6%

B 10%

C 15%

D 17%

28. BRW Co has 10% redeemable loan notes in issue trading at $90. The loan notes are redeemable at a 10% premium in 5 years time, or convertible at that point into 20 ordinary shares. The current share price is $2.50 and is expected to grow at 10% per annum for the foreseeable future. BRW Co pays 30% corporation tax.

What is the best estimate of the cost of these loan notes?

A 9.8%

B 7.9%

C 11.5%

D 15.2%

29. HB Co has in issue 10% irredeemable loan notes, currently traded at 95% cum-interest.

If the tax rate changes from 30% to 20% for the company, the cost of irredeemable debt:

A Increases to 9.4%

B Increases to 8.4%

C Decreases to 9.4%

D Decreases to 8.4%

30. An 8% irredeemable $0.50 preference share is being traded for $0.30 cum-div currently in a company that pays corporation tax at a rate of 30%.

What is the cost of capital for these preference shares?

A 10.8%

B 15.4%

C 26.7%

D 18.7%

V. WACC

31. Ardotalia Co has irredeemable loan stock with a nominal value of $6m on which it pays interest at the rate of 10% per year. The market value of the loan stock is currently $8 million and the corporation tax rate is 20%. The company also has equity shares in issue with a market capitalisation of $12 million. The weighted average cost of capital of the company is 12%.

What is the company’s cost of equity?

A 13·3%

B 14·7%

C 15·0%

D 16·0%

32. Leto plc has 10 million $1·00 ordinary shares in issue that have a current market value of $2·00 per share. The company also has irredeemable loan capital in issue with a nominal value of $20 million that is quoted at $150 per $100 nominal value. The cost of ordinary shares is estimated at 15% and the rate of interest on the loan capital is 12%. The rate of corporation tax is 25%.

What is the weighted average cost of capital for the company?

A 13·0%

B 11·4%

C 11·0%

D 13·2%

33. The validity of using the existing weighted average cost of capital as the appropriate discount rate for deducing the net present value of a project rests on a number of key assumptions. These include the following:

1. The investment project has the same level of risk as those projects normally undertaken by the business.

2. The investment project is small in relation to the size of the business.

Which one of the following combinations (true/false) concerning the above statements is correct?

| |Statement 1 |Statement 2 |

|A |True |True |

|B |True |False |

|C |False |True |

|D |False |False |

34. Legis plc has 20 million £0·50 ordinary shares and irredeemable loan capital with a nominal value of £40 million in issue. The ordinary shares have a current market value of £2·40 per share and the loan capital is quoted at £80 per £100 nominal value. The cost of ordinary shares is estimated at 11% and the cost of loan capital is calculated to be 8%. The rate of corporation tax is 25%.

What is the weighted average cost of capital for the company?

A 7·0%

B 9·0%

C 9·5%

D 9·8%

35. Amur Co has 10 million $1 ordinary shares in issue that have a current market value of $2·40 per share. The cost of the equity shares is estimated at 12% per year. The company also has irredeemable, 9% loan notes in issue with a nominal value of $40 million, which are quoted at $120 per $100 nominal value. The rate of taxation is 20%.

What is the weighted average cost of capital for the company?

A 7·2%

B 8·0%

C 8·2%

D 9·6%

36. ABC Co has a capital structure as follows:

| |$m |

|10m $0.50 ordinary shares |5 |

|Reserves |20 |

|13% irredeemable loan notes |7 |

| |32 |

The ordinary shares are currently quoted at $3.00, and the loan notes at $90. ABC Co has a cost of equity of 12% and pays corporation tax at a rate of 30%.

What is ABC Co’s weighted average cost of capital?

A 10.4%

B 11.1%

C 11.7%

D 11.8%

37. Which of the following are assumed if a company’s current weighted average cost of capital (‘WACC’) is to be used to appraise a potential project?

1 Capital structure will remain unchanged for the duration of the project

2 The business risk of the project is the same as the current business operations

3 The project is relatively small in size

A 1 and 2 only

B 2 and 3 only

C 1 and 3 only

D 1, 2 and 3

|Question 2 – WACC, business valuation and capital structure |

|KFP Co, a company listed on a major stock market, is looking at its cost of capital as it prepares to make a bid to buy a rival |

|unlisted company, NGN. Both companies are in the same business sector. Financial information on KFP Co and NGN is as follows: |

| |

| |

|KFP Co |

| |

|NGN |

| |

| |

| |

|$m |

|$m |

|$m |

|$m |

| |

|Non-current assets |

| |

|36 |

| |

|25 |

| |

|Current assts |

|7 |

| |

|7 |

| |

| |

|Current liabilities |

|3 |

| |

|4 |

| |

| |

|Net current assts |

| |

|4 |

| |

|3 |

| |

|Total assets less current liabilities |

| |

|40 |

| |

|28 |

| |

| |

| |

| |

| |

| |

| |

|Ordinary shares, par value 50c |

|15 |

| |

|5 |

| |

| |

|Retained earnings |

|10 |

| |

|3 |

| |

| |

|Total equity |

| |

|25 |

| |

|8 |

| |

|7% bonds, redeemable at par in seven years’ time |

| |

|15 |

| |

| |

| |

|9% bonds, redeemable at par in two years’ time |

| |

| |

| |

|20 |

| |

|Total equity and non-current liabilities |

| |

|40 |

| |

|28 |

| |

| |

|Other relevant financial information: |

|Risk-free rate of return 4·0% |

|Average return on the market 10·5% |

|Taxation rate 30% |

| |

|NGN has a cost of equity of 12% per year and has maintained a dividend payout ratio of 45% for several years. The current earnings per |

|share of the company is 80c per share and its earnings have grown at an average rate of 4·5% per year in recent years. |

| |

|The ex div share price of KFP Co is $4·20 per share and it has an equity beta of 1·2. The 7% bonds of the company are trading on an ex |

|interest basis at $94·74 per $100 bond. The price/earnings ratio of KFP Co is eight times. |

| |

|The directors of KFP Co believe a cash offer for the shares of NGN would have the best chance of success. It has been suggested that a |

|cash offer could be financed by debt. |

| |

| |

|Required: |

| |

|(a) Calculate the weighted average cost of capital of KFP Co on a market value weighted basis. (10 marks) |

|(b) Calculate the total value of the target company, NGN, using the following valuation methods: |

|(i) Price/earnings ratio method, using the price/earnings ratio of KFP Co; and |

|(ii) Dividend growth model. (6 marks) |

|(c) 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) |

|(25 marks) |

|(ACCA F9 Financial Management June 2009 Q1) |

Chapter 16 Capital Structure

I. Capital structure theories

1. Which of the following statements is part of the traditional theory of gearing?

A There must be taxes

B There must exist a minimum WACC

C Cost of debt increases as gearing decreases

D Cost of equity increases as gearing decreases

2. A Co’s gearing is 1:1 Debt:equity. The industry average is 1:5. A Co are looking to raise finance for investment in a new project and they are wondering whether to raise debt or equity.

According to the traditional view:

A They should take on debt finance as to do so will save tax.

B They should take on equity finance as their gearing is probably beyond optimal.

C It doesn’t matter as it won’t affect the returns the projects generate.

D More information is needed before a decision can be made.

3. Why do Modigliani-Miller (with tax) assume increased gearing will reduce the weighted average cost of capital (‘WACC’)?

A Debt is cheaper than equity

B Interest payments are tax deductible

C Reduced levels of expensive equity capital will reduce the WACC

D Financial risk is not pronounced at moderate borrowing levels

4. Consider the following statements concerning capital structure.

According to both the traditional view and the Modigliani and Miller (including taxes) view of capital structure:

1. the point at which the weighted average cost of capital is minimised provides the optimal capital structure for a company

2. the weighted average cost of capital is minimised at the maximum level of gearing

Which one of the following combinations (true/false) concerning the above statements is correct?

| |Statement 1 |Statement 2 |

|A |True |True |

|B |True |False |

|C |False |True |

|D |False |False |

5. The Modigliani and Miller (with taxes) proposition concerning capital gearing states that as the level of capital gearing of a business increases from zero, there will be an initial increase in the:

1. cost of loan capital

2. weighted average cost of capital

3. value of the business

4. cost of equity capital

Which two of the above statements are correct?

A 1 and 2

B 1 and 4

C 2 and 3

D 3 and 4

6. Three views concerning the effect of loan capital on the capital structure of a business are:

1. The traditional view.

2. The Modigliani and Miller (without taxes) view.

3. The Modigliani and Miller (with taxes) view.

According to each view, what will be the effect (rise/fall/stay constant) on the cost of equity when the level of loan capital increases?

| |Traditional view |Modigliani and Miller (without taxes)|Modigliani and Miller (with taxes) |

| | |view |view |

|A |Rise |Rise |Rise |

|B |Fall |Stay constant |Rise |

|C |Rise |Stay constant |Fall |

|D |Fall |Fall |Fall |

7. The Modigliani and Miller (no taxes) proposition concerning capital gearing states that, as the level of capital gearing increases from zero:

A the cost of equity capital will remain unchanged

B the weighted average cost of capital will decrease

C the value of the business will remain unchanged

D the cost of loan capital will increase

8. Consider the following statements concerning capital structure:

According to the Modigliani and Miller (ignoring taxes) view of capital structure

1. the market value of a geared business is equal to the market value of a similar, ungeared (all-equity financed) business.

2. the cost of equity in a geared company is equal to the cost of equity in a similar, ungeared (all equity financed) business.

Which one of the following combinations (true/false) concerning the above statements is correct?

| |Statement 1 |Statement 2 |

|A |True |True |

|B |True |False |

|C |False |True |

|D |False |False |

9. Consider the following statements concerning capital structure:

According to Modigliani and Miller (without taxes)

1. The cost of equity in a geared company is equal to the cost of equity in a similar ungeared company.

2. The cost of debt will remain the same, irrespective of the level of gearing.

Which one of the following combinations (true/false) relating to the above statements is correct?

| |Statement 1 |Statement 2 |

|A |True |True |

|B |True |False |

|C |False |True |

|D |False |False |

10. Which of the following statements concerning capital structure theory is correct?

A In the traditional view, there is a linear relationship between the cost of equity and financial risk

B Modigliani and Miller said that, in the absence of tax, the cost of equity would remain constant

C Pecking order theory indicates that preference shares are preferred to convertible debt as a source of finance

D Business risk is assumed to be constant

(ACCA F9 Financial Management Pilot Paper 2014)

11. A company incorporates increasing amounts of debt finance into its capital structure, while leaving its operating risk unchanged.

Assuming that a perfect capital market exists, with corporation tax (but without personal tax), which of the following correctly describes the effect on the company’s costs of capital and total market value?

| |Cost of equity |WACC |Total market value |

|A |Increases |Unaffected |Increases |

|B |Unaffected |Decreases |Increases |

|C |Increases |Decreases |Increases |

|D |Decreases |Increases |Decreases |

12. SD Co increased its gearing and its weighted average cost of capital reduced.

Which of the following theories might explain this?

1 Modigliani-Miller (with tax)

2 The traditional view

3 Pecking order theory

4 Modigliani-Miller (no tax)

A 1, 2 and 3 only

B 1 and 4 only

C 1 and 2 only

D 2 and 4 only

13. Pecking order theory suggests finance should be raised in which order?

A Internal funds, rights issue, debt

B Internal funds, debt, new equity

C Debt, internal funds, new equity

D Rights issue, internal funds, debt

|Question 3 – WACC, traded bond and value of a company |

|The finance director of AQR Co has heard that the market value of the company will increase if the weighted average cost of capital of |

|the company is decreased. The company, which is listed on a stock exchange, has 100 million shares in issue and the current ex div |

|ordinary share price is $2·50 per share. AQR Co also has in issue bonds with a book value of $60 million and their current ex interest |

|market price is $104 per $100 bond. The current after-tax cost of debt of AQR Co is 7% and the tax rate is 30%. |

| |

|The recent dividends per share of the company are as follows. |

|Year |

|2006 |

|2007 |

|2008 |

|2009 |

|2010 |

| |

|Dividend per share (cents) |

|19.38 |

|20.20 |

|20.41 |

|21.02 |

|21.80 |

| |

| |

|The finance director proposes to decrease the weighted average cost of capital of AQR Co, and hence increase its market value, by |

|issuing $40 million of bonds at their par value of $100 per bond. These bonds would pay annual interest of 8% before tax and would be |

|redeemed at a 5% premium to par after 10 years. |

| |

|Required: |

| |

|(a) Calculate the market value after-tax weighted average cost of capital of AQR Co in the following circumstances: |

|(i) before the new issue of bonds takes place; |

|(ii) after the new issue of bonds takes place. |

|Comment on your findings. (12 marks) |

|(b) Identify and discuss briefly the factors that influence the market value of traded bonds. (5 marks) |

|(c) Discuss the director’s view that issuing traded bonds will decrease the weighted average cost of capital of AQR Co and thereby |

|increase the market value of the company. (8 marks) |

|(25 marks) |

|(ACCA F9 Financial Management June 2011 Q2) |

II. CAPM and M&M combined

14. Galanthus plc is a recently listed company that is financed entirely by equity shares. The directors of the company wish to establish the likely beta value of the equity shares and wish to use data from Hesperis plc, a similar listed company within the same industry, to do this. Hesperis plc has an equity beta of 1·2 and is financed by 60% equity shares and 40% loan capital. The loan capital of the company can be regarded as risk-free and the rate of corporation tax is 20%.

What is the estimated equity beta for Galanthus plc, based on the information above?

A 0·52

B 0·78

C 0·82

D 0·90

15. Two companies are identical in every respect except for their capital structure. Paro Co is financed entirely by equity, whereas Tzia Co has 30% debt and 70% equity. The beta value for Paro Co is 1·5 and the tax rate is 20%. What is the estimated beta value for the equity of Tzia Co?

A 2·0

B 1·9

C 1·8

D 1·6

16. Why is an asset beta generally lower than an equity beta?

A An equity beta also includes an element of financial risk

B Returns from assets are tax deductible.

C Asset betas contain less business risk

D Capital markets are generally more efficient than business operations.

17. When should a project-specific cost of capital be used for investment appraisal?

A If new finance is required before the project can go ahead.

B If the project is small.

C If the project is different from current operations.

D If the project is the same as current operations.

18. What does tax exhaustion mean?

A All avenues have been explored to minimise corporation tax.

B As deductions have reduced tax payable to zero, further deductions won’t save tax.

C Non current assets have a zero tax written down value.

D Tax liabilities have been completely discharged.

The following information relates to questions 19 and 20

.

TR Co has a gearing level of 1:3 debt : equity. TR is considering diversifying into a new market. B Co is already operating in the new market. B Co has an equity beta of 1.05 and a gearing level of 1:4 Debt : equity. Both companies pay 30% corporation tax.

19. What is the asset beta relevant to TR for the new market?

A 0.89

B 0.84

C 0.28

D 0.75

20. The risk free rate is 4% and the market premium is 4%.

What is TR Co’s cost of equity for assessing the decision to diversify into the new market?

A 4%

B 7.6%

C 8.4%

D 6.3%

|Question 4 – Project-specific discount rate and limitation of CAPM |

|Explain how the capital asset pricing model can be used to calculate a project-specific discount rate and discuss the limitations of |

|using the capital asset pricing model in investment appraisal. (11 marks) |

|(ACCA F9 Financial Management December 2008 Q3(c)) |

|Question 5 – WACC, project-specific discount rate, systematic and unsystematic risk |

|The equity beta of Fence Co is 0·9 and the company has issued 10 million ordinary shares. The market value of each ordinary share is |

|$7·50. The company is also financed by 7% bonds with a nominal value of $100 per bond, which will be redeemed in seven years’ time at |

|nominal value. The bonds have a total nominal value of $14 million. Interest on the bonds has just been paid and the current market |

|value of each bond is $107·14. |

| |

|Fence Co plans to invest in a project which is different to its existing business operations and has identified a company in the same |

|business area as the project, Hex Co. The equity beta of Hex Co is 1·2 and the company has an equity market value of $54 million. The |

|market value of the debt of Hex Co is $12 million. |

| |

|The risk-free rate of return is 4% per year and the average return on the stock market is 11% per year. Both companies pay corporation|

|tax at a rate of 20% per year. |

| |

|Required: |

| |

|(a) Calculate the current weighted average cost of capital of Fence Co. (7 marks) |

|(b) Calculate a cost of equity which could be used in appraising the new project. |

|(4 marks) |

|(c) Explain the difference between systematic and unsystematic risk in relation to portfolio theory and the capital asset pricing |

|model. (6 marks) |

|(ACCA F9 Financial Management June 2014 Q3(a), (b) & (c)) |

|Question 6 – WACC, project-specific discount rate |

|AMH Co wishes to calculate its current cost of capital for use as a discount rate in investment appraisal. The following financial |

|information relates to AMH Co: |

| |

|Financial position statement extracts as at 31 December 2012 |

| |

|$000 |

|$000 |

| |

|Equity |

| |

| |

| |

|Ordinary shares (nominal value 50 cents) |

|4,000 |

| |

| |

|Reserves |

|18,000 |

|22,000 |

| |

|Long-term liabilities |

| |

| |

| |

|4% Preference shares (nominal value $1) |

|3,000 |

| |

| |

|7% Bonds redeemable after six years |

|3,000 |

| |

| |

|Long-term bank loan |

|1,000 |

|7,000 |

| |

| |

| |

|29,000 |

| |

| |

|The ordinary shares of AMH Co have an ex div market value of $4·70 per share and an ordinary dividend of 36·3 cents per share has just|

|been paid. Historic dividend payments have been as follows: |

|Year |

|2008 |

|2009 |

|2010 |

|2011 |

| |

|Dividend per share (cents) |

|30.9 |

|32.2 |

|33.6 |

|35.0 |

| |

| |

|The preference shares of AMH Co are not redeemable and have an ex div market value of 40 cents per share. The 7% bonds are redeemable |

|at a 5% premium to their nominal value of $100 per bond and have an ex interest market value of $104·50 per bond. The bank loan has a |

|variable interest rate that has averaged 4% per year in recent years. |

| |

|AMH Co pays profit tax at an annual rate of 30% per year. |

| |

|Required: |

| |

|(a) Calculate the market value weighted average cost of capital of AMH Co. (12 marks) |

|(b) Discuss how the capital asset pricing model can be used to calculate a project-specific cost of capital for AMH Co, referring in |

|your discussion to the key concepts of systematic risk, business risk and financial risk. (8 marks) |

|(c) Discuss why the cost of equity is greater than the cost of debt. (5 marks) |

|(25 marks) |

|(ACCA F9 Financial Management June 2013 Q2) |

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ACCA Dec 2014 Dec 2014

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