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PFM 5-1

Question 194 to 237
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?

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

A. Accounting profit can be manipulated by managers

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B. Accounting profit is not the same as economic profit

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C. Profit takes account of risk

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

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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?

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197. Which of the following describes a sukuk?

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

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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?

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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?

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

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

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

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

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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

 

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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

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B. Operating risk

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

rj = rf + βj (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%.

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

A. Security X

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B. Security Y

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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?

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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:

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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.

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

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

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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?

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

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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

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219. Which of the following best describes systematic risk?

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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)?

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

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

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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?

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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?

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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.

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B. The project is relatively small in size

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

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

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

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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?

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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?

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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?

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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.

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B.

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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?

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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)?

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