Section 1

1 Which of the following statements is/are correct?

1. Monetary policy seeks to influence aggregate demand by increasing or decreasing the money
raised through taxation
2. When governments adopt a floating exchange rate system, the exchange rate is an equilibrium
between demand and supply in the foreign exchange market
3. Fiscal policy seeks to influence the economy and economic growth by increasing or decreasing
interest rates

A 2 only
B 1 and 2 only
C 1 and 3 only
D 1, 2 and 3

2 Which of the following statements are correct?

(1) The general level of interest rates is affected by investors’ desire for a real return
(2) Market segmentation theory can explain kinks (discontinuities) in the yield curve
(3) When interest rates are expected to fall, the yield curve could be sloping downwards
A 1 and 2 only
B 1 and 3 only
C 2 and 3 only
D 1, 2 and 3

3 The following information relates to a company:

Year 0 1 2 3
Earnings per share (cents) 30·0 31·8 33·9 35·7
Dividends per share (cents) 13·0 13·2 13·3 15·0
Share price at start of year ($) 1·95 1·98 2·01 2·25

Which of the following statements is correct?

A The dividend payout ratio is greater than 40% in every year in the period
B Mean growth in dividends per share over the period is 4%
C Total shareholder return for the third year is 26%
D Mean growth in earnings per share over the period is 6% per year

4 Which of the following statements is correct?

A. One of the problems with maximising accounting profit as a financial objective is that accounting profit
can be manipulated
B. A target for a minimum level of dividend cover is a target for a minimum dividend payout ratio
C. The welfare of employees is a financial objective
D. One reason shareholders are interested in earnings per share is that accounting profit takes account
of risk
5 Which of the following statements is correct?

A. Once purchased, currency futures have a range of close-out dates

6 Crag Co has sales of $200m per year and the gross profit margin is 40%. Finished goods inventory days
vary throughout the year within the following range:
Maximum Minimum
Inventory (days) 120 90
All purchases and sales are made on a cash basis and no inventory of raw materials or work in
progress is carried. Crag Co intends to finance permanent current assets with equity and fluctuating
current assets with its overdraft.
In relation to finished goods inventory and assuming a 360-day year, how much finance will
be needed from the overdraft?

2 $10m
3 $17m
4 $30m
5 $40m

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

A As risk rises, the market value of the security will fall to ensure that investors receive an increased yield
B As risk rises, the market value of the security will fall to ensure that investors receive a reduced yield
C As risk rises, the market value of the security will rise to ensure that investors receive an increased
yield
D As risk rises, the market value of the security will rise to ensure that investors receive a reduced yield

8 Which of the following statements concerning working capital management are correct?
1 Working capital should increase as sales increase
2 An increase in the cash operating cycle will decrease profitability
3 Overtrading is also known as under-capitalisation

A 1 and 2 only
B 1 and 3 only
C 2 and 3 only
D 1, 2 and 3

9 Which of the following is LEAST likely to fall within financial management?

A The dividend payment to shareholders is increased

10 Which of the following statements is correct?

A Governments may choose to raise interest rates so that the level of general expenditure in the
economy will increase
 B The normal yield curve slopes upward to reflect increasing compensation to investors for being unable
to use their cash now
C The yield on long-term loan notes is lower than the yield on short-term loan notes because long-term
debt is less risky for a company than short-term debt
D Expectations theory states that future interest rates reflect expectations of future inflation rate
movements

11 A company has just paid an ordinary share dividend of 32·0 cents and is expected to pay a dividend of
33·6 cents in one year’s time. The company has a cost of equity of 13%.

What is the market price of the company’s shares to the nearest cent on an ex dividend basis?
A. $3·20
B. $4·41
C. $2·59
D. $4·20

12 Which of the following is/are usually seen as forms of market failure where regulation may be a
solution?

1 Imperfect competition
2 Social costs or externalities
3 Imperfect information

A 1 only
B 1 and 2 only
C 2 and 3 only
D 1, 2 and 3

13 Country X uses the dollar as its currency and country Y uses the dinar. Country X’s expected inflation rate is
5% per year, compared to 2% per year in country Y. Country Y’s nominal interest rate is 4% per year and the
current spot exchange rate between the two countries is 1·5000 dinar per $1.

According to the four-way equivalence model, which of the following statements is/are true?
1. Country X’s nominal interest rate should be 7·06% per year
2. The future (expected) spot rate after one year should be 1·4571 dinar per $1
3. Country X’s real interest rate should be higher than that of country Y

A 1 only
B 1 and 2 only
C 2 and 3 only
D 1, 2 and 3

14 Which of the following government actions would lead to an increase in aggregate demand?
(1) Increasing taxation and keeping government expenditure the same
(2) Decreasing taxation and increasing government expenditure
(3) Decreasing money supply
(4) Decreasing interest rates

A 1 only
B 1 and 3
C 2 and 4 only
D 2, 3 and 4
15 Peach Company’s results are as follows
$000
Profit before interest and taxation 2,500
Profit before taxation 2,250
Profit after tax 1,400

In addition, extracts from its latest statement of financial position are as follows:

$000
Equity 10,000
Non-current liabilities 2,500

What is Peach Co’s return on capital employed (ROCE)?

A 14%
B 18%
C 20%
D 25%
Section 3

Question 31
Hebac Co is preparing to launch a new product in a new market which is outside its current business
operations. The company has undertaken market research and test marketing at a cost of $500,000, as a
result of which it expects the new product to be successful. Hebac Co plans to charge a lower selling
price initially and then increase the selling price on the assumption that the new product will establish
itself in the new market. Forecast sales volumes, selling prices and variable costs are as follows:

Year 1 2 3 4
Sales volume (units/year) 200,000 800,000 900,000 400,000
Selling price ($/unit) 15 18 22 22
Variable costs ($/unit) 9 9 9 9

Selling price and variable cost are given here in current price terms before taking account of forecast
selling price inflation of 4% per year and variable cost inflation of 5% per year.

Incremental fixed costs of $500,000 per year in current price terms would arise as a result of
producing the new product. Fixed cost inflation of 8% per year is expected.

The initial investment cost of production equipment for the new product will be $2·5 million, payable
at the start of the first year of operation. Production will cease at the end of four years because the
new product is expected to have become obsolete due to new technology. The production equipment
would have a scrap value at the end of four years of $125,000 in future value terms.

Investment in working capital of $1·5 million will be required at the start of the first year of operation.
Working capital inflation of 6% per year is expected and working capital will be recovered in full at the
end of four years.

Hebac Co pays corporation tax of 20% per year, with the tax liability being settled in the year in which
it arises. The company can claim tax-allowable depreciation on a 25% reducing balance basis on the
initial investment cost, adjusted in the final year of operation for a balancing allowance or charge.
Hebac Co currently has a nominal after-tax weighted average cost of capital (WACC) of 12% and a
real after-tax WACC of 8·5%. The company uses its current WACC as the discount rate for all
investment projects.

Required:

(a) Calculate the net present value of the investment project in nominal terms and comment
on its financial acceptability. (12 marks)

(b) Discuss how the capital asset pricing model can assist Hebac Co in making a better
investment decision with respect to its new product launch. (8 marks)

Question 32
Tinep Co is planning to raise funds for an expansion of existing business activities and in preparation for this
the company has decided to calculate its weighted average cost of capital. Tinep Co has the following capital
structure:

$m $m
Equity
Ordinary shares 200
Reserves 650
––––
850
Non-current liabilities
 Loan notes 200
––––––
1,050
––––––

The ordinary shares of Tinep Co have a nominal value of 50 cents per share and are currently
trading on the stock market on an ex dividend basis at $5·85 per share. Tinep Co has an equity beta
of 1·15.

The loan notes have a nominal value of $100 and are currently trading on the stock market on an ex
interest basis at $103·50 per loan note. The interest on the loan notes is 6% per year before tax and
they will be redeemed in six years’ time at a 6% premium to their nominal value.

The risk-free rate of return is 4% per year and the equity risk premium is 6% per year. Tinep Co pays
corporation tax at an annual rate of 25% per year.

Required:

(a) Calculate the market value weighted average cost of capital and the book value weighted average
cost of capital of Tinep Co, and comment briefly on any difference between the two values. (12 marks)

(b) Discuss the factors to be considered by Tinep Co in choosing to raise funds via a rights issue. 8 marks)