Section A Trial exam JJ22 – Questions 1-15.

C1: Financial management function

1. Fitz Frazel Co has just paid a dividend of 25c per share for the year just ended out of earnings per share of 41c. Its
share price is $3.80 per share. One year ago, Fitz Frazel Co made earnings per share of 33c and the price/earnings
ratio was 10.

What is the total shareholder return over the period just ended?

A. 15.2%
B. 13.2%
C. 22.7%
D. 19.7%

C2: Financial management environment

2. The government of a modern industrialised economy has adopted the following measures.

1. Increased government spending

2. Reduced interest rates
3. Increased taxation for companies

Which of these policies would be part of an expansionary economic policy?

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

C3: Working capital investment

3. The monthly demand for Product Z is 30,000 units and currently inventory is ordered in quantities of 18,000 units.
A delivery cost of $300 is charged by the supplier for each delivery regardless of its size. There are no further
administrative costs connected with ordering the product. The cost of holding one unit of product Z is $0.15 per
year. A buffer inventory equal to 9,000 units is maintained.

What is the economic order quantity for Product Z to the nearest 1,000 units?

A. Zero units
B. 1,000 units
C. 11,000 units
D. 38,000 units

C4: Cash management and working capital finance

4. Hawns Co uses Miller-Orr to control its cash balances. It has a lower limit of $5,000 and a spread of $18,000.

Which of the following statements are consistent with the use of Miller-Orr?

1. When cash balances rise to $18,000, Hawns Co buys $8,666 of short-term securities
2. When cash balances fall to $5,000, Hawns Co sells $6,000 of short-term securities

A. 1 only
B. 2 only
C. Both 1 and 2
 D. Neither 1 nor 2

C5: Investment decision

5. Which of the following is/are true of the payback method of investment appraisal?

1. It tends to maximise financial and business risk.

2. It’s a fairly complex technique and not easy to understand.
3. It cannot be used when there is a capital rationing situation.

A. None of these
B. All of these
C. 1 only
D. 2 and 3 only

C6: Allowing for tax, working capital and inflation

6. AW Co needs to have $100,000 working capital in place immediately for the start of 2- year project. The amount
will stay constant in real terms. Inflation is running at 10% per year, and AW Co's money cost of capital is 12%.

What is the present value of cash flows relating to working capital?

A. $(21,260)
B. $(20,300)
C. $(108,730)
D. $(4,090)

C7: Project appraisal and risk

7. AZ Yet Co financial year end is on 31 September. On 1 October 2020 a new machine costing $2,000,000 is
purchased. The company expects to sell the machine on 31 September 2022 for $500,000. Tax allowable
depreciation is obtained at 25% on the reducing balance basis and a balancing allowance is available on disposal
of the asset. The effective rate of corporation tax for the company is 35% and is paid one year in arrears. AZ Yet
Co makes sufficient profits to obtain relief for tax allowable depreciation as soon as they arise.

If the company's cost of capital is 10% per annum, what is the present value of the tax allowable depreciation
(to the nearest $1,000)?

A. $525,000
B. $407,000
C. $432,000
D. $448,000

C9: Sources of finance

8. Jon and Majid have entered into a Sharia’s compliant partnership contract whereby Jobling and Majid both
contribute capital and expertise in equal proportion. They have agreed that profits from the partnership will be
shared in a ratio of 65:35 in favour of Jon. The partnership has made a loss of $10,000.

How much of the loss should be attributed to Majid?

A. Nil
B. $5,000
C. $3,500
D. $10,000

C10: Dividend policy

9. The following information relates to Derby Co.

20X7 20X8 20X9

Earnings after tax ($'000) 25,000 28,000 37,000
Preference dividend (1,000) (1,000) (1,000)
Ordinary shares in issue ('000) 10,000 14,000 14,000
Ordinary dividend per share ($) 0.588 0.42 0.42
Capital expenditure 6,000 72,000 17,000

The following statements have been made in relation to Derby Co's dividend policy.

1. The company is pursuing a dividend policy consistent with Modigliani and Miller's irrelevancy theory.
2. The company's total dividend payout has fallen between 20X7 and 20X9.

Which of these statements is/are true?

A. 1 only
B. 2 only
C. Both 1 and 2
D. Neither 1 nor 2

Q10 – C12: Capital structure

10. 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 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 plc 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 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 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.

C12: Capital structure

11. Why do Modigliani and 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 level of expensive debt equity capital will reduce the WACC.
D. Financial risk is not pronounced at moderate borrowing levels.

C14: Foreign currency risk

12. Which of the following derivative instruments are characterised by a standard contract size?

1. Futures contract
2. Exchange-traded option
 3. Forward rate agreement
4. Swap

A. 1 and 2
B. 2 and 3
C. 3 and 4
D. 1 and 4

C14: Foreign currency risk

13. A company whose home currency is the dollar ($) expects to receive 500,000 pesos in 6 months' time from a
customer in a foreign country. The following interest rates and exchange rates are available to the company:

Spot rate – 15.00 peso per $

Six-month forward rate – 15.30 peso per $

Home country Foreign country

Borrowing interest rate 4% per year 8% per year
Deposit interest rate 3% per year 6% per year

Working to the nearest $100, what is the six-month dollar value of the expected receipt using a money market
hedge?

A. $32,500
B. $33,700
C. $31,800
D. $31,900

C15: Interest rate risk

14. Today is 1 January 2020. Snooper Co will borrow $5 million on 31 March 2020 and will repay this debt on 31
December 2020.

LIBOR is currently at 1.0% and Snooper Ltd can borrow short-term debt at 3% above LIBOR.
A forward rate agreement is available for Snooper Ltd at 1.25%.

Which of the following statements is/are true?

A. The appropriate type of forward rate agreement in this case would be a 3–9 FRA.
B. The FRA rate would be 5.25%.
C. If LIBOR was 0.75% on 31 March 2020, this would result in an obligation on Snooper Ltd to make an FRA
payment.
D. If LIBOR was 0.75% on 31 March 2020, the FRA payment or receipt would be $25,000.

C15: Interest rate risk

15. Which of the following statements is/are true about Forward Rate Agreements?

1. They can be used to reduce interest rate risk on existing loans

2. They are usually only available on large scale loans

A. 1 only
B. 2 only
C. Both 1 and 2
D. Neither
Section B Trial exam JJ22 – Questions 16-30.

C14 & 15: Foreign currency risk & Interest rate risk

Case 1

Kerrin Co’s finance director is concerned about the effect of future interest rates on the company and has been looking at
the yield curve.

Kerrin Co, whose domestic currency is the dollar ($), plans to take out a $100m loan in three months’ time for a period of
nine months. The company is concerned that interest rates might rise before the loan is taken out and its bank has offered
a 3 v 12 forward rate agreement at 7.10 – 6.85.

The loan will be converted into pesos and invested in a nine-month project which is expected to generate income of 580m
pesos, with 200m pesos being paid in six months’ time (from today) and 380m pesos being paid in 12 months’ time (from
today). The current spot exchange rate is 5 pesos per $1.

The following information on current short-term interest rates is available:

Dollars 6.5% per year
Pesos 10.0% per year

As a result of the general uncertainty over interest rates, Kerrin Co is considering a variety of ways in which to manage its
interest rate risk, including the use of derivatives.

16. In relation to the yield curve, which of the following statements is correct?

A. A kink in the normal yield curve can be due to differing yields in different market segments.
B. Expectations theory suggests that deferred consumption requires increased compensation as maturity
increases.
C. Basis risk can cause the corporate yield curve to rise more steeply than the government yield curve.
D. An inverted yield curve can cause by government action to increase its long-term borrowing.

17. If the interest rate on the loan is 6.5% when it is taken out, what is the nature of the compensatory payment under
the forward rate agreement?

A. Kerrin Co pays bank $250,000

B. Kerrin Co pays bank $600,000
C. Kerrin Co pays bank $450,000
D. Bank pays Kerrin Co $600,000

18. Using exchange rates based on interest rate parity, what is the dollar income received from the project?

A. $116.0m
B. $112.3m
C. $112.9m
D. $114,1m

19. In respect of Kerrin Co managing its interest rate risk, which of the following statements is/are correct?

(1) Smoothing is an interest rate risk hedging technique which involves maintaining a balance between assets
and liabilities.
(2) Matching is an interest rate risk hedging technique which involves maintaining a balance between fixed-rate
and floating-rate debt.

A. 1 only
B. 2 only
 C. Both 1 and 2
D. Neither 1 nor 2

20. In relation to the use of derivatives by Kerrin Co, which of the following statements is correct?

A. An interest rate swap is an agreement to exchange both principal and interest rate payments
B. Kerrin Co can hedge interest rate on borrowing by selling a floor and buying a cap
C. Kerrin Co can hedge interest rate risk on borrowing by buying interest rate futures now and selling them back
in the future
D. Interest rate options must be exercised on their expiry date, if they have not been exercised before then.

C13: Business valuations

Case 2

Extract from the financial statements of Bluebell Co, a listed company, are as follows:

$m
Profit before interest and tax 238
Finance costs (24)
Profit before tax 214
Corporation tax (64)
Profit after tax 150

Assets
Non – current assets
Property, plant and equipment 768
Goodwill (internally generated) 105
873
Current assets
Inventories 285
Trade receivables 192
477
Total assets 1350

Equity and liabilities

Total equity 688
Non-current liabilities
Long-term borrowings 250
Current liabilities
Trade payables 312
Short-term borrowings 100
Total current liabilities 412
Total liabilities 662

Total equity and liabilities 1350

A similar size competitor company has a price/earnings ratio of 12.5 times.

This competitor believes that if Bluebell Co were liquidated, property, plant and equipment would only realise $600m, while
10% of trade receivables would be irrecoverable and inventory would be sold at $30m less than its book value.

Separately, Bluebell Co is considering the acquisition of Dandelion Co, an unlisted company which is a supplier of Bluebell
Co.

21. What is the value of Bluebell Co on a net realizable value basis?

 A. $140.8m
B. $470.8m
C. $365.8m
D. $1,207.8m

22. What is the value of Bluebell Co using the earnings yield method?

A. $2,675m
B. $1,200m
C. $1,875m
D. $2,975m

23. When valuing Bluebell Co using asset-based valuations, which of the following statements is correct?

A. An asset-based valuation would be useful for an asset-stripping acquisition

B. Bluebell Co’s workforce can be valued as an intangible asset
C. Asset-based valuations consider the present value of Bluebell Co’s future income
D. Replacement cost basis provides a deprival value for Bluebell Co

24. Which of the following is/are indicators of market imperfections?

(1) Low volume of trading in shares of smaller companies

(2) Overreaction to unexpected news

A. 1 only
B. 2 only
C. Both 1 and 2
D. Neither 1 nor 2

25. Which of the following statements is correct?

A. Dandelion Co is easier to value than Bluebell Co because a small number of shareholders own all the shares
B. Bluebell Co will have to pay a higher price per share to take control of Dandelion Co than if it were buying a
minority holding
C. Scrip dividends decrease the liquidity of shares by retaining cash in a company
D. Dandelion Co’s shares will trade at a premium to similar listed shares because it will have a lower cost of
equity

C12: Capital structure

Case 3

Rose Co is a large company with an equity beta of 1.05 (geared company). The company plans to expand existing business
by acquiring a new factory at a cost of $20m. The finance for the expansion will be raised from an issue of 3% loan notes,
issued at nominal value of $100 per loan note. These loan notes will be redeemable after five years at nominal value or
convertible at that time into ordinary shares in Rose Co with a value expected to be $115 per loan note.

The risk-free rate of return is 2.5% and the equity risk premium is 7.8%.

Rose Co is seeking additional finance and is considering using Islamic finance and in particular would require a form which
would be similar to equity financing.
26. What is the cost of equity of Rose Co using the capital asset pricing model?

A. 13.3%
B. 10.7%
C. 8.1%
D. 10.3%

27. Using estimates of 5% and 6%, what is the cost of debt of the convertible loan notes?

A. 3.0%
B. 5.2%
C. 6.9%
D. 5.7%

28. In relation to using the dividend growth model to value Rose Co, which of the following statements is correct?

A. The model assumes that all shareholders of Rose Co have the same required rate of return
B. The model assumes a constant share price and a constant dividend growth for Rose Co
C. The model assumes that capital markets are semi-strong form efficient
D. The model assumes that Rose Co’s interim dividend is equal to the final dividend

29. Which of the following statements about equity finance is correct?

A. Equity finance reserves represent cash which is available to a company to invest

B. Additional equity finance can be raised by rights issues and bonus issues
C. Retained earnings are a source of equity finance
D. Equity finance includes both ordinary shares and preference shares

30. Regarding Rose Co’s interest in Islamic finance, which of the following statements is/are correct?

(1) Murabaha could be used to meet Rose Co’s financing needs

(2) Mudaraba involves an investing partner and a managing or working partner

A. 1 only
B. 2 only
C. Both 1 and 2
D. Neither 1 nor 2

Section C Trial exam JJ22 – Questions 31-32.

Question 31
Corfe Co is preparing a cash flow forecast for the three-month period from January to the end of March. The following
sales volumes have been forecast:

December January February March April

Sales (units) 1,200 1,250 1,300 1,400 1,500

Notes:

1. The selling price per unit is $800 and a selling price increase of 5% will occur in February. Sales are all on one
month's credit.
2. Production of goods for sale takes place one month before sales.
3. Each unit produced requires two units of raw materials, costing $200 per unit. No raw materials inventory is held.
Raw material purchases are on one month's credit.
4. Variable overheads and wages equal to $100 per unit are incurred during production and paid in the month of
production.
5. The opening cash balance at 1 January is expected to be $40,000.
6. A long-term loan of $300,000 will be received at the beginning of March.
7. A machine costing $400,000 will be purchased for cash in March.

Required:

(a) Calculate the cash balance at the end of each month in the three-month period. (5marks)

(b) Calculate the forecast current ratio at the end of the three-month period. (2marks)

(c) Assuming that Corfe Co expects to have a short-term cash surplus during the three-month period, discuss whether
this should be invested in shares listed on a large stock market. (3marks)

(d) Explain how the Baumol model can be employed to reduce the costs of cash management. (5marks)

(e) Degnis Co, a subsidiary of Corfe Co, has set a minimum cash account balance of $7,500. The average cost to the
company of making deposits or selling investments is $18 per transaction and the standard deviation of its cash
flows was $1,000 per day during the last year. The average interest rate on investments is 5.11%.

Determine the spread, the upper limit and the return point for the cash account of Degnis Co using the Miller-Orr
model and explain the relevance of these values for the cash management of the company. (5marks)

(Total = 20 marks)

Question 32

A colleague has been taken ill. Our managing director has asked you to take over from the colleague and to provide
urgently needed estimates of the discounts rate to be used in appraising a large new investment. You have been given
your colleague’s working notes which believe to be numerically accurate.

Working notes:

Estimates for the next five years (annual averages)

Stock market total return on equity 16%

Own company dividend yields 7%
Own company share price rise 14%
Own company equity Beta 1.4
Growth rate of own company earnings 12%
Growth rate of own company dividends 11%
 Growth rate of own company sales 13%
Treasury bill yield 12%

The company’s gearing level (by market) is 1:2 debt to equity, and after-tax earnings available to ordinary shareholders in
the most recent year were $5,400,000 of which $2,140,000 was distributed as ordinary dividends. The company has 10
million issued ordinary shares, which are currently trading on the Stock Exchange at 321 cents. Corporate debt may be
assumed to be risk-free. The company pays tax at 35% and personal taxation may be ignored.

Required:

(a) Estimate the company’s weighted average cost of capital using:

i. The dividend valuation model

ii. The capital asset pricing model.

State clearly any assumptions that you make.

Under what circumstances would these models be expected to produce similar values for the weighted average cost
of capital.
(9 marks)

(b) You are now informed that the proposed investment is a major diversification into a new industry, and are provided
with the following information about the new industry:
Average industry gearing level (by market value) 1:3 debt to equity
Average β equity 1:50

Using any relevant information from parts (a) and (b), recommend which cost of equity should be used for the
investment. Any relevant calculations not included in your answer to part (a) should form part of your answer.
(6 marks)

(c) Discuss the problems estimating the appropriate data inputs for using the capital assets pricing model in investment
appraisal.
(5 marks)

(Total=20 marks)