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PFM 5-1

Question 194 to 237

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

	W plc	X plc	Y plc	Z plc
	%	%	%	%
Equity as a proportion of total market capitalisation	70	20	65	40
Debt as a proportion of total market capitalisation	30	80	35	60

The equity beta of W plc is 0.89 and the equity beta of Z plc is 1.22.

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

The beta of X plc and the beta of Y plc are both higher than 1.22.

The beta of X plc is below 0.89 and the beta of Y plc is in the range 0.89 to 1.22.

The beta of X plc is above 1.22 and the beta of Y plc is in the range 0.89 to 1.22.

The beta of X plc is in the range 0.89 to 1.22 and the beta of Y plc is higher than 1.22.

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195. Indicate whether the following statements concerning profit is true or false?

A. Accounting profit can be manipulated by managers

True

False

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B. Accounting profit is not the same as economic profit

True

False

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C. Profit takes account of risk

True

False

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D. Gross profit margin is calculated as gross profit divided by shareholder’s funds

True

False

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194. The equity shares of Gloss plc have a beta value of 0.80. The risk free rate of return is 6% and the market risk premium is 4%. Corporation tax is 30%.

What is the required return on the shares of Gloss plc (to one decimal place)?

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197. Which of the following best describes the term ‘coupon rate’ as it applies to bonds?

Annual interest received as a percentage of the ex interest market price of the bond

Return received taking into account capital repayment as well as interest payments

Annual interest received as a percentage of the cum-interest market price of the bond

Annual interest received as a percentage of the nominal value of the bond

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197. Which of the following describes a sukuk?

Equity in Islamic finance where profits are shared according to a pre-agreed contract – dividends are not paid as such

A bond in Islamic finance where the lender owns the underlying asset and shares in the risks and rewards of ownership

A lease in Islamic finance where the lessor retains ownership and the risk and rewards of ownership of the underlying asset

Trade credit in Islamic finance where a pre-agreed mark-up is agreed in advance for the convenience of paying later

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199. Which TWO of the following statements about bonds is correct?

Eurobonds are short-term loans raised by international companies or other institutions

Unsecured bonds are likely to require a higher yield to maturity than equivalent secured bonds.

Convertible bonds give the borrower the right but not the obligation to turn the bond into a predetermined number of ordinary shares.

A Eurobond is a bond that is denominated in a currency which is not native to where the bond itself is issued.

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200. Alpha is a listed company with a share price of $2 per share. It announces a 1 for 4 rights issue at $1.60 per share. What is the theoretical ex-rights price (to two decimal places)?

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201. Which of the following statements is correct?

Shareholders usually have the power to increase dividends at annual general meetings of a company.

A bonus issue can be used to raise new equity finance.

Miller and Modigliani argued that the financing decision is more important than the dividend decision.

A share repurchase scheme can increase both earnings per share and gearing.

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202. A company has just declared an ordinary dividend of 25.6p per share; the cum-div market price of an ordinary share is 280p.

Assuming a dividend growth rate of 16% per annum, what is the company’s cost of equity capital (to one decimal place)?

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203. Which of the following statements is true of a scrip issue with perfect information?

Increases the market price of the share

Decreases the debt/equity ratio (calculated on a market value basis) of the company

Decreases earnings per share

Increases individual shareholder wealth

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204. Which TWO of the following would be implied by a decrease in a company’s operating gearing ratio?

The company has profits which are less sensitive to changes in sales volume

The company has a lower proportion of costs that are variable

The company is less risky

The company is less profitable

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

There must be taxes

There must exist a minimum WACC

Cost of debt increases as gearing decreases

Cost of equity increases as gearing decreases 104

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206. In Modigliani and Miller’s dividend irrelevance theory, the process of ‘manufacturing dividends’ refers to which of the following?

Creative accounting to allow dividends to be paid

Dividends from manufacturing businesses

Investing plans designed to create regular returns to shareholders

Investors selling some shares to realise some capital gain

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207. In which of the following situations is a residual dividend most likely to be appropriate?

A small listed company owned by investors seeking maximum capital growth on their investment

A large publicly listed company

In a tax regime where individuals pay less tax on dividend income than on capital gains

A small family-owned private company where the majority of the shareholders use dividend income to pay their living costs

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208. Three companies (S Co, M Co and N Co) have the following dividend payments history:

Company	20X1	20X2	20X3
S Co – Dividend	100	110	121
S Co – Earnings	200	200	201
M Co – Dividend	50	150	25
M Co – Earnings	100	300	50
N Co – Dividend	nil	300	nil
N Co – Earnings	400	350	500

Which best describes their apparent dividend policies?

S Co	M Co	N Co
A. Constant growth	Constant payout	Residual
B. Constant payout	Constant growth	Residual
C. High payout	Residual	Constant payout
D. Constant growth	Residual	Constant payout

A

B

C

D

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209. If for a given level of activity a firm’s ratio of variable costs to fixed costs were to fall and, at the same time, its ratio of debt to equity were also to fall, what would be the effect on the firm’s financial and operating risk? Indicate, by clicking in the relevant boxes, whether financial risk and operating risk would increase or decrease.

A. Financial risk

Increase

Decrease

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B. Operating risk

Increase

Decrease

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

r_j= r_f+ β_j(r_m – r_f)

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%.

Indicate whether the pricing of securities X and Y is over or underpriced?

A. Security X

Overpriced

Underpriced

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B. Security Y

Overpriced

Underpriced

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211. A summary of MAS Co’s recent statement of profit or loss is given below:

	$’000
Revenue	10,123
Cost of sales	(7,222)
Gross profit	2,901
Expenses	(999)
Profit before interest and tax	1,902
Interest	(1,000)
Tax	(271)
Profit after interest and tax	631

70% of cost of sales and 10% of expenses are variable costs.

What is MAS Co’s operational gearing (as a number to two decimal places)?

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212. The following are extracts from the statement of financial position of a company

	$000	$000
Equity
Ordinary shares	8,000
Reserves	20,000
		28,000
Non-current liabilities
Bonds	4,000
Bank loans	6,200
Preference shares	2,000
		12,200
Current liabilities
Overdraft	1,000
Trade payables	1,500
		2,500
Total equity and liabilities		42,700

The ordinary shares have a nominal value of 50 cents per share and are trading at $5.00 per share. The preference shares have a nominal value of $1.00 per share and are trading at 80 cents per share. The bonds have a nominal value of $100 and are trading at $105 per bond.

What is the market value based gearing of the company, defined as prior charge capital/equity?

7.5%

14.0%

15.0%

11.8%

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213. All else being equal, a poor set of results and lower dividends that aren’t as bad as shareholders were expecting would probably have the following impact:

Increase (P/E ratio) & Increase (Dividend yield )

Decrease (P/E ratio) & Increase (Dividend yield )

Increase (P/E ratio) & Decrease (Dividend yield )

Decrease (P/E ratio) & Decrease (Dividend yield )

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214. Indicate whether the following statements, relating to supply chain finance (SCF), are true or false?

A. SCF is considered to be financial debt.

True

False

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B. SCF allows an SME to raise finance at a lower interest rate than would normally be available to it.

True

False

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215. Which TWO of the following are most likely to result in a company’s financial gearing being high?

High tax rates

Low taxable profits

Intangible assets being a low proportion of total assets

Inexpensive share issue costs

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216. A company is going to take on a project using a mix of equity and debt finance in an economy where the corporation tax rate is 30%. Assuming perfect markets, other than tax, which of the following statements is true about the project?

βe < βa; WACC > Cost of equity calculated using βa; WACC < Cost of equity calculated using βe

βe < βa; WACC > Cost of equity calculated using βa; WACC > Cost of equity calculated using βe

βe > βa; WACC < Cost of equity calculated using βa; WACC < Cost of equity calculated using βe

βe > βa; WACC < Cost of equity calculated using βa; WACC > Cost of equity calculated using βe

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217. Compared to ordinary secured loan notes, which of the following statements is true when considering convertible secured loan notes?

Likely to be more expensive to service because converting to equity requires the holders to make additional payments

Likely to be less expensive to service because of their equity component

Likely to be more expensive to service because of their equity component

Likely to be less expensive to service because they must rank after ordinary secured loan stock

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218. Which of the following are handicaps that young SMEs face in accessing funds?

1 Uncertainty and risk for lenders

2 Financial statements are not sufficiently detailed

3 Shares cannot be placed privately

1 and 2 only

1 and 3 only

2 only

1, 2 and 3

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219. Which of the following best describes systematic risk?

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

The chance that automated processes may fail

The diversifiable risk associated with investing in equity

The risk associated with investing in equity

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220. SJ Co has a cost of equity of 25%. It has 4 million shares in issue, and has done for many years. Its dividend payments in the years 20X9 to 20Y3 were as follows.

End of year	Dividends
	$’000
20X9	220
20Y0	257
20Y1	310
20Y2	356
20Y3	423

Dividends are expected to continue to grow at the same average rate into the future. According to the dividend valuation model, what should be the share price at the start of 20Y4 (to two decimal places)?

$1.73

$2.24

$3.01

$1.05

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221. Which of the following does NOT directly affect a company’s cost of equity?

The company’s beta

Expected market return

Return on assets

Risk-free rate of return

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222. In relation to an irredeemable security paying a fixed rate of interest, which of the following statements is correct?

As risk rises, the market value of the security will rise to ensure that investors receive a reduced yield

As risk rises, the market value of the security will rise to ensure that investors receive an increased yield

As risk rises, the market value of the security will fall to ensure that investors receive an increased yield

As risk rises, the market value of the security will fall to ensure that investors receive a reduced yield

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223. Serotin Co has $5m of $0.50 nominal value ordinary shares in issue. It recently announced a 1 for 4 rights issue at $6 per share. Its share price on the announcement of the rights issue was $8 per share. What is the theoretical value of a right per existing share?

$0.50

$1.60

$1.20

$1.50

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224. Small and medium-sized entities (SMEs) can have difficulty raising finance due to the maturity gap. Which of the following is the best explanation of the maturity gap?

Venture capitalists need an exit route for their investment within a specific time period

The lack of business history makes borrowing more risky for lenders

The lack of available funds from shareholders

The business finds it difficult to obtain short-term funding but easier to obtain longterm funding secured against its non-current assets

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225. A share in PQ Co has an equity beta of 1.3. PQ 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%. PQ Co pays 30% corporation tax. What is the cost of equity for PQ Co?

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226. Which of the following are assumed if a company’s current WACC is to be used to appraise a potential project?

A. Capital structure will remain unchanged for the duration of the project.

True

False

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B. The project is relatively small in size

True

False

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C. The business risk of the project is the same as the current business operations.

True

False

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227. What is the dividend cover ratio a measure of?

How many times the company’s earnings could pay the dividend

The interest or coupon rate expressed as a percentage of the market price

How much of the overall dividend pay-out the individual shareholders are entitled to

The returns to the investor by taking about of dividend income and capital growth

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228. In relation to long-term leases, which TWO of the following statements are true?

Many leases can be offered in sequence to cover the whole of useful life of the asset

The lessor retains the risks and rewards of ownership

The lessee is responsible for repairs and maintenance

The lease agreement cannot be cancelled

44 / 53

229. Kodel 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 year for the foreseeable future. Kodel Co pays 30% corporation tax. What is the best estimate of the cost of these loan notes (to one decimal place)?

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230. ODS 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. ODS Co has a cost of equity of 12% and pays corporation tax at a rate of 30%.

What is ODS Co’s weighted average cost of capital (WACC)?

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231. JSK Co, a listed company, had the following share prices during the year ended 31 December 20X5:

At start of 20X5 $2.50

Highest price in the year $3.15

Lowest price in the year $2.40

At end of 20X5 $3.00

During the year, JSK Co paid a total dividend of $0.15 per share.

What is the total shareholder return for 20X5?

22%

26%

32%

36%

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232. Carp Co has announced that it will pay an annual dividend equal to 55% of earnings. Its earnings per share is $0.80 and it has ten million shares in issue. The return on equity of Carp Co is 20% and its current cum dividend share price is $4.60. What is the cost of equity of Carp Co?

19.4%

28.0%

20.5%

22.7%

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233. 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 (to one decimal place)? %

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234. Leah Co is an all-equity financed company which wishes to appraise a project in a new area of business. Its existing equity beta is 1.2. The average equity beta for the new business area is 2.0, with an average debt/debt plus equity ratio of 25%. The risk-free rate of return is 5% and the market risk premium is 4%.

Ignoring taxation and using the capital asset pricing model, what is the risk-adjusted cost of equity for the new project?

13.0%

9.8%

8.6%

11.0%

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235. Director A believes there is an optimal balance of debt:equity whereas Director B does not believe that the gearing decision affects the value of the business. Match the capital structure theory that best reflects each of directors’ beliefs.

Theory Director

Traditional view A?

M&M (no tax)

M&M (with tax) B?

Pecking order

A.

Director A

Director B

51 / 53

B.

Director A

Director B

52 / 53

236. Alf Co’s gearing is 1:1 debt:equity. The industry average is 1:5. Alf Co is looking to raise finance for investment in a new project and it is wondering whether to raise debt or equity. Applying the traditional view, which of the following is true?

It should take on debt finance, as to do so will save tax

It should take on equity finance, as their gearing is probably beyond optimal

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

More information is needed before a decision can be made

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237. Zam Co is a company that manufactures factory machines. It has an equity beta of 1.6 and a debt:equity ratio of 1:3. It is considering a new project to manufacture factory Trant Co is a manufacturer of factory vehicles and has an asset beta of 1.1 and a debt:equity ratio of 2:3. The risk free rate of return is 5%, the market risk premium is 3% and the corporation tax rate is 40%.

Using CAPM, what would be the suitable cost of equity for Zam Co to use in its appraisal of the factory vehicles project (to one decimal place)?