F3 Financial Strategy Questions and Answers

Semi-strong form efficiency means all publicly available information is already in the share price; only new information about future cash flows or risk will change shareholder wealth.

A positive-NPV project creates new value → share price should rise on announcement.

The other options (unchanged dividend, revaluation, impairment) either convey no new value creation, or even bad news (impairment).

Answer: A. Announcing that a project will be undertaken generating a positive net present value.

The bid is hostile and partly for diversification. Directors’ primary duty is to shareholders: they should explain why they believe the company is undervalued (e.g. unannounced plans and cash). Changing articles or using defensive payouts is poor governance; competition concerns are unlikely to be central here.

Answer: A. Write to shareholders explaining fully why the company's share price is undervalued.

A poison pill is designed to deter hostile bidders by making a takeover much more costly. When triggered, it usually issues new shares or converts rights at favorable terms to existing shareholders (other than the bidder), diluting the bidder’s stake.

Here, rights to buy future preference shares convert into full ordinary shares, increasing the number of shares in issue and making it more expensive for BCD to gain control. That directly reduces the attractiveness and feasibility of the hostile bid.

 Covenants are mainly there to protect the lender (B),

 to impose financial discipline on the borrower (C), and

 if breached, they usually give the lender rights to call in the loan or renegotiate (D).

They are not designed simply to penalise the company (A) or eliminate tax (E).

Discursive_F0

Current profit after tax (PAT) = $750,000.

After sale, extra directors’ salaries (pre-tax) = $50,000.

Tax rate = 20% → tax saving on extra salaries = 50,000 × 20% = 10,000.

So reduction in PAT = 50,000 − 10,000 = $40,000.

Maintainable PAT = 750,000 − 40,000 = $710,000.

Using P/E of 7:

Value = 710,000 × 7 = $4,970,000.

✅ Answer: D. $4,970,000

CIMA F3 clearly distinguishes between not-for-profit/public sector organisations and for-profit private sector organisations, particularly in relation to objectives, performance measurement, and stakeholder focus.

Statement A – Correct

Clinic A is funded by central government and provides free healthcare. This fits the CIMA F3 definition of a not-for-profit (public sector) organisation, whose primary purpose is service delivery rather than profit generation.

Clinic B is a listed company owned by shareholders and charges patients directly, making it a for-profit organisation.

✔ Therefore, statement A is correct.

Statement B – Incorrect

Maximising shareholder wealth is the primary financial objective only of for-profit companies, such as Clinic B.

Public sector organisations like Clinic A do not have shareholders and therefore cannot have shareholder wealth maximisation as an objective.

✘ Statement B is incorrect.

Statement C – Correct

CIMA F3 teaches that public sector organisations are primarily assessed on value for money, which incorporates:

Economy

Efficiency

Effectiveness

Since Clinic A is government-funded, its performance would be appraised mainly using value-for-money criteria rather than profitability.

✔ Statement C is correct.

Statement D – Incorrect

While Clinic B may consider some non-financial objectives (such as service quality or reputation), its primary objectives are financial, particularly profit and shareholder wealth maximisation.

The statement implies equal weighting, which is inconsistent with CIMA F3 theory.

✘ Statement D is incorrect.

Statement E – Correct

Despite differing ownership and funding, both organisations share the same primary non-financial objective: the provision of quality healthcare.

CIMA F3 highlights that organisations in the same sector often share common service objectives, regardless of profit motive.

✔ Statement E is correct.

At 1 Jan:

Cost of equity, ke=10%k_e = 10\%ke​=10%

Cost of debt, kd=5%k_d = 5\%kd​=5%

Debt D=100D = 100D=100

Shares = 100m @ $4 → Equity E0=400E_0 = 400E0​=400

Total value V0=D+E0=500V_0 = D + E_0 = 500V0​=D+E0​=500.

WACC under Modigliani & Miller (no tax):

k0=E0V0ke+DV0kd=400500⋅10%+100500⋅5%=8%+1%=9%k_0 = \frac{E_0}{V_0}k_e + \frac{D}{V_0}k_d = \frac{400}{500} \cdot 10\% + \frac{100}{500} \cdot 5\% = 8\% + 1\% = 9\%k0​=V0​E0​​ke​+V0​D​kd​=500400​⋅10%+500100​⋅5%=8%+1%=9%

k0k_0k0​ stays constant.

After the share price falls to $3:

Equity E1=100m×3=300E_1 = 100m \times 3 = 300E1​=100m×3=300

Debt still 100 → D/E1=100/300=0.3333D/E_1 = 100/300 = 0.3333D/E1​=100/300=0.3333

MM no-tax formula:

ke=k0+(k0−kd)DE=9%+(9%−5%)⋅100300=9%+4%⋅0.3333≈9%+1.33%=10.33%k_e = k_0 + (k_0 - k_d)\frac{D}{E} = 9\% + (9\% - 5\%) \cdot \frac{100}{300} = 9\% + 4\% \cdot 0.3333 \approx 9\% + 1.33\% = 10.33\%ke​=k0​+(k0​−kd​)ED​=9%+(9%−5%)⋅300100​=9%+4%⋅0.3333≈9%+1.33%=10.33%

Rounded → 10.3%.

In CIMA F3, rights issues and post-issue valuation are taught under the learning outcomes relating to financing decisions, equity issuance, and shareholder value analysis. The Theoretical Ex-Rights Price (TERP) represents the price a share should trade at immediately after the rights issue when the “value dilution” and “value added” of the project are taken into account.

According to the financial strategy principles taught in F3, the TERP is calculated by adding:

The current market value of equity,

The cash raised from the rights issue, and

The net present value (NPV) of the investment project,

then dividing by the total number of shares after the issue. This reflects the CIMA F3 view that share prices should adjust to reflect both new financing inflows and future economic benefits associated with positive-NPV projects.

Step-by-step application of the F3 method

(1) Current shareholders’ equity value:

(2) Rights issue price:

Rights issued at a 10% discount:

(3) Number of new shares issued:

(4) Total shares after issue:

(5) Total value after issue and project:

Add value of cash raised and NPV:

(6) TERP formula:

Rounded to two decimal places:

This calculation follows the CIMA F3 principle that positive-NPV projects increase shareholder wealth, and therefore must be added to the total post-issue company valuation before dividing by the enlarged share capital.

The project lasts four years and will be sold at the end; the firm wants to minimise annual cashflow payments on the debt.

Bank loans and finance leases usually require amortising payments (interest + principal) → higher annual cashflows.

Standard bonds pay full coupon at market rate → higher annual interest than bonds with attached warrants.

Bonds with warrants allow investors extra value via the warrant, so the coupon can be set lower, cutting annual interest payments; principal is typically repaid at maturity, matching the project sale.

Answer: A. Bonds with warrants

Competition authorities focus primarily on market structure and competition, not on whether the bid is generous or on employment promises. Their concern is: Will this merger substantially lessen competition?

In food retailing, a key issue is local market concentration – for example, a single group owning too many supermarkets in particular towns or regions. A classic remedy is for the bidder to divest overlapping outlets so that effective competition remains.

B. Agreeing to dispose of specified outlets which overlap geographically directly addresses the competition authority’s main concern and is the standard structural remedy used in practice.

A (more cash) is irrelevant to competition issues.

C (job guarantees) is mainly a political/employment concern, not an antitrust one.

D (promise to pass on cost savings) is difficult to monitor and enforce and is normally viewed as less credible than structural remedies.

So the action most likely to persuade the competition authorities is B.

Use CAPM:

10%=1%+β(7%−1%)⇒0.10=0.01+0.06β⇒β=0.09/0.06=1.510\% = 1\% + \beta(7\% - 1\%) \Rightarrow 0.10 = 0.01 + 0.06\beta \Rightarrow \beta = 0.09/0.06 = 1.510%=1%+β(7%−1%)⇒0.10=0.01+0.06β⇒β=0.09/0.06=1.5.

Beta > 1 ⇒ higher risk than the market.

Answer: A. It has greater risk than the average market risk.

We want methods that give the value of equity, not the value of the whole entity.

A. D₁ / (kₑ – g) → Gordon growth dividend model = value of equity (share value). ✅

B. Total earnings × P/E → market capitalisation = equity value. ✅

C. Free cash flows to all investors discounted at WACC → enterprise / firm value (equity + debt). ❌

D. Free cash flows to equity discounted at cost of equity → equity value. ✅

E. NCA + CA − CL → value of net assets before deducting long-term debt, i.e. value of the business to all capital providers, not just equity. ❌

So correct choices: A, B, D.

According to Modigliani and Miller with tax, the value of a levered firm is:

VL=VU+Tc×DV_L = V_U + T_c \times DVL​=VU​+Tc​×D

where TcT_cTc​ is the corporate tax rate and DDD is the market value of debt. With corporate income tax, interest is tax-deductible, so increasing debt creates a tax shield and increases total firm value.

Initially:

Debt = 40

Equity = 60

Total value = 100

Tax rate = 20%.

If the company increases debt and uses the proceeds to buy back shares until debt equals equity, then:

New structure: D=ED = ED=E

Total firm value rises because Tc×DT_c \times DTc​×D increases.

The extra value (PV of the additional tax shield) accrues to shareholders, even though the accounting market value of equity after the buyback may fall in absolute terms; shareholders have also received cash from the buyback, so their total wealth increases.

Business risk (and therefore asset beta) is unchanged; however equity beta would rise, not fall, because of higher financial leverage. Therefore the only correct statement is that the plan would increase shareholder wealth – answer C.

A. Private company buys back the equity shares – VC can sell its shares back to the company → full exit.

C. Company obtains a stock market listing – creates a market for the shares; VC can sell on IPO or in the market → exit.

E. Trade sale of shares to an external 3rd party – classic VC exit route.

A rights issue (B) or stock split (D) do not, by themselves, provide an exit – they just change capital structure or number of shares.

Disadvantages of accepting cash for ZYY’s shareholders:

A. Low interest rates – cash reinvested in deposits earns little.

B. Capital gains tax is crystallised on disposal.

E. No chance to share in YZZ’s future growth once they’ve taken cash.

C and D are not disadvantages of cash (D is actually an advantage: certainty).

Pre-acquisition:

Company X: earnings = $50m, P/E = 10 → value = 50 × 10 = $500m; shares = 100m → price = $5

Company Y: earnings = $15m, P/E = 10 → value = 15 × 10 = $150m; shares = 50m → price = $3

Combined earnings = 50 + 15 = $65m

Post-acquisition assumptions:

Earnings increase by 10% → 65 × 1.10 = $71.5m

Combined P/E remains 10 → total market value = 71.5 × 10 = $715m

We want X’s new share price to be 10% higher than $5 → target price = $5.50.

Share price = total value ÷ total X shares after issue:

5.50=715Total shares⇒Total shares=7155.5=130m5.50 = \frac{715}{\text{Total shares}} \Rightarrow \text{Total shares} = \frac{715}{5.5} = 130\text{m}5.50=Total shares715​⇒Total shares=5.5715​=130m

X currently has 100m shares, so must issue 30m new shares to Y’s shareholders.

Y has 50m shares → each Y share must get:

30m50m=0.6 X shares per Y share\frac{30m}{50m} = 0.6 \text{ X shares per Y share}50m30m​=0.6 X shares per Y share

Check options:

B: 3 X for 5 Y → 3/5 = 0.6 X per Y ✔

So that exchange ratio gives exactly 30m new X shares and hence a 10% increase in X’s share price.

Correct answer: B – 3 shares in Company X for 5 shares in Company Y.

 A – True. A special dividend can create expectations of similar future payouts, while a buyback is more clearly one-off.

 B – True. A repurchase can be interpreted by some investors as management having no positive-NPV projects, i.e. a possible negative signal about growth opportunities.

 C – False. The repurchase price is not automatically the open-market price; it may involve negotiation or a premium/discount.

 D – True. In many tax regimes, capital gains (from buybacks) are taxed more favourably than dividend income, so some shareholders may prefer repurchases.

 E – False. Even if approved, individual shareholders are usually free to choose whether or not to tender their shares.

Key convertible bond points:

Investors accept a lower coupon on convertibles because they get the equity conversion option.

If converted, no new cash comes in: debt simply becomes equity.

On conversion, debt falls and equity rises, so gearing falls, not rises.

So:

A – False (convertible debt is usually cheaper, not more expensive).

B – False (no extra cash on conversion).

C – True (coupon is usually lower on convertibles).

D – False (conversion lowers gearing).

Answer Q73: C

PPP fails in practice when prices of goods can’t equalise across countries because of frictions or structural differences:

B. Consumer tastes – different baskets of goods, so the “same” price index isn’t really comparable.

D. Import tariffs – artificial price wedges created by governments.

E. Transport costs – make it impossible to arbitrage price differences away fully.

Arbitrage (A) actually helps PPP hold, not prevents it, and differing tax regimes (C) are less central in standard PPP discussions than tariffs and transport.

✅ Answer Q122: B, D, E

For a capital-intensive, fast-growing, owner-managed start-up with many investment opportunities, the most suitable policy is to retain earnings to finance all positive NPV projects first, and only pay dividends out of any leftover (residual) earnings. That’s exactly what a residual dividend policy does.

In semi-strong form market efficiency, share prices reflect all publicly available information, and they react quickly and unbiasedly to new public announcements.

Here, the share price was fairly static before the profit warning, then fell 20% on the day of the announcement. That suggests:

The market did not know this bad news beforehand.

When the profit warning was announced (new public info), the price immediately adjusted.

That is classic semi-strong efficiency behaviour.

Weak form only says prices reflect past price data, not necessarily public news.

Strong form would imply even insider information is already reflected, so you might have seen movement before the announcement.

“Random walk” describes the pattern of price movements, not a level of efficiency in this context.

Notional principal = $200m

Pay fixed 4%, receive floating (6-month risk-free).

For the first 6 months, the floating rate fixed on 1 Jan = 5% p.a.

Difference = 5% − 4% = 1%

Settlement for 6 months:

0.01×200 m×612=$1 000 0000.01 \times 200\,\text{m} \times \frac{6}{12} = \$1\,000\,0000.01×200m×126​=$1000000

Floating > fixed, so the company receives this amount under the swap.

Correct answer: D. $1,000,000 net receipt to the company.

B. New profitable contract improves the company’s credit quality → lower default risk → investors accept a lower yield.

C. Convertible bond gives investors equity upside → they are willing to accept a lower coupon / YTM than on an equivalent straight bond.

A (shorter term) might affect yield, but the effect depends on the yield curve, so it’s less clear-cut.

D (unsecured instead of secured) increases risk, so yield would rise, not fall.

Competition authorities are mainly concerned with market power and abuse of dominance.

Proposing to increase prices significantly on routes where no other airlines operate (i.e. monopoly routes) is a classic competition concern → C.

Reducing destinations (A), selective disclosure to shareholders (B), or redundancies (D) are governance, disclosure, or employment issues, not the core focus of competition law.

The division is loss-making, with poor management and obsolete assets. It needs a $20m investment, but PV of future cash flows is only $15m → negative NPV of –$5m if retained.

The company wants to raise cash, so methods that don’t raise cash (de-merger, spin-off) are inappropriate.

Trade sale (C): sell the division to another company that may be better able to invest/manage it – brings in cash.

Liquidation (D): close the division and sell the assets – also raises cash and avoids further losses.

MBO (A) is unlikely, since current management is identified as part of the problem.

Answer: C and D

Newly established, unincorporated service entity → focuses on growth, service quality and staying liquid; dividends and optimal capital structure are not primary yet.

Answer: B, C, D

Workings (Modigliani & Miller with tax):

Current (unlevered) cost of capital ku=9%k_u = 9\%ku​=9%

Cost of debt kd=3%k_d = 3\%kd​=3%

Tax rate T=25%T = 25\%T=25%

Target D/E=1/2=0.5D/E = 1/2 = 0.5D/E=1/2=0.5

Formula with tax:

ke=ku+(ku−kd)(1−T)DEk_e = k_u + (k_u - k_d)(1-T)\frac{D}{E}ke​=ku​+(ku​−kd​)(1−T)ED​ ke=9%+(9%−3%)×0.75×0.5=9%+6%×0.375=9%+2.25%=11.25%≈11.3%k_e = 9\% + (9\% - 3\%) \times 0.75 \times 0.5 = 9\% + 6\% \times 0.375 = 9\% + 2.25\% = 11.25\% \approx 11.3\%ke​=9%+(9%−3%)×0.75×0.5=9%+6%×0.375=9%+2.25%=11.25%≈11.3%

So the nearest option is 11.3% (C).

Interest rate parity (IRP) says the forward exchange rate adjusts so that investors earn the same return in different currencies once hedged, otherwise arbitrage profits would exist. If parity doesn’t hold, traders can lock in risk-free gains, and their trades push rates back to parity.

So the model works well because:

Answer: C – Any divergence from parity can be observed by the market and corrected by arbitrage.

Once Division B is sold, Division A becomes heavily reliant on B as a major external customer. If the new owner reduces purchases or switches supplier, Division A’s volumes and viability are at risk. That makes:

C. Division A's going concern is highly dependent on its relationship with Division B – the main risk.

Company X is an established, unquoted, specialist IT advisory firm with steady results, predictable dividends and cashflows. Company P is only buying 30% (a minority stake).

B. Dividend based using DVM – Very suitable because dividends are predictable and regular. For a minority stake, dividends are often the main measurable return, so a dividend valuation model is appropriate.

C. Cash based using free cash flow before interest – A DCF valuation based on free cash flow to the firm is also appropriate for a profitable, growing, going concern. You can value the whole business using FCFF and then take 30% of the equity value.

Asset-based (A) is less relevant for a specialist service company with relatively few tangible assets. P/E-based methods (D and E) are less ideal given there are few direct competitors, making comparables unreliable.

Company currently pays fixed 7% on its bonds.

Swap quote 6.0%–6.5% fixed against LIBOR means:

Bank will pay 6.0% fixed and receive LIBOR, or

Receive 6.5% fixed and pay LIBOR.

To move from fixed to variable, the company should receive fixed and pay LIBOR, so it takes the 6.0% fixed leg.

Net position:

Pay 7% fixed on bond

Receive 6% fixed from swap

Pay LIBOR on swap

Total = (7% − 6%) + LIBOR = LIBOR + 1%

Answer: C. VARIABLE at LIBOR + 1.0%

1. Sell from domestic market

Revenue = A$100,000

Costs (given) = A$45,000

Import duty = 10% of 100,000 = A$10,000 (tax-deductible)

Profit before tax = 100,000 − 45,000 − 10,000 = A$45,000

Tax at 25% = 0.25 × 45,000 = A$11,250

Profit after tax = 45,000 − 11,250 = A$33,750

2. Sell via foreign subsidiary

Revenue = B$104,500

Costs = B$49,500

Profit before tax = 104,500 − 49,500 = B$55,000

Tax at 30% = 0.30 × 55,000 = B$16,500

Profit after tax = 55,000 − 16,500 = B$38,500

Convert to A$ at A$1 = B$1.10:

A$ profit = 38,500 / 1.10 = A$35,000

Foreign subsidiary gives the higher after-tax profit.

Answer: C. Foreign subsidiary: A$35,000

A scrip dividend (stock dividend) means shareholders receive additional shares instead of cash. CIMA F3 explains that this is commonly used when a company wants to maintain a “visible” dividend policy but conserve cash because of short-term liquidity or profit pressures. Shareholders get something of value – more shares – while the company avoids a large immediate cash outflow, keeping funds available to support operations and future growth.

In the scenario, the company has strong long-term prospects but current profit and cash-flow problems. That is exactly the situation where F3 suggests that a scrip dividend is attractive: it encourages shareholders to leave cash in the business while still signalling confidence.

A is incorrect: a scrip dividend does not raise new external finance; it just capitalises reserves. B is wrong because issuing more shares normally reduces earnings per share, all else equal. D is misleading: dividend per share usually falls or at best is unchanged in cash terms; what increases is the number of shares, not the cash amount per share. Therefore, C is the most appropriate reason.

In CIMA F3, capital structure choice affects tax, risk and shareholder expectations. Debt interest is tax-deductible whereas dividends are not, so using more debt reduces taxable profit. Therefore statement A (“no impact on tax”) is false. Retained earnings are not “free”: shareholders could have taken that cash and invested elsewhere, so the cost of retained earnings equals the cost of equity – B is false.

As gearing rises, equity becomes riskier because fixed interest must be paid before any earnings go to shareholders. Under Modigliani–Miller with or without tax, this raises the cost of equity, so D is true. Replacing debt with equity reduces the probability of default and so reduces overall financial risk, making E true.

Issuing more equity increases the number of shares; investors will expect dividends on those shares in future, so total dividend outflows are likely to rise even if DPS stays the same. This added distribution pressure makes F true. C (“debt is always preferable”) is rejected in F3 because of higher financial risk and potential increase in WACC beyond an optimal gearing level.

A scrip issue (bonus issue) is just slicing the same “pie” into more pieces – no new value is created.

Issue: 1 new share for every 4 existing → after the issue, each holder who had 4 shares will now have 5.

Total value before = 4 shares × $20 = $80.

After the issue, that $80 is spread over 5 shares:

Price after=805=$16\text{Price after} = \frac{80}{5} = \$16Price after=580​=$16

So the best estimate of the ex-scrip share price is $16.00.

The items that most clearly enhance shareholder wealth are those that increase future cash flows or create valuable strategic assets:

D. Exploiting production synergies – cost savings / higher margins.

E. Elimination of existing competition – greater pricing power and market share.

F. Acquiring intellectual property assets – unique products, barriers to entry, licensing income.

Issue price at 20% discount to $5 = $4 per share.

Amount to raise = 20m → new shares = 20m / 4 = 5m.

Existing shares = 20m → rights ratio = 5m : 20m = 1 : 4.

Answer: A. 1 new share for every 4 existing shares

Current:

Revenue = $450m at $2.50/kWh → units = 450 / 2.5 = 180m kWh

Costs = $250m → Profit = $200m

After cap: price = $2.00, demand up 15%:

New volume = 180 × 1.15 = 207m kWh

New revenue = 207 × 2.00 = $414m

Costs unchanged = $250m → New profit = 414 − 250 = $164m

Answer: B. $164.00 million profit

Profit before tax = $4.0m

Tax at 25% → earnings = $4.0m × (1 − 0.25) = $3.0m

For a takeover, the most relevant comparators are recent takeover P/E multiples in the same industry: 9–10x.

Minimum value = 3.0 × 9 = $27m

Maximum value = 3.0 × 10 = $30m

Answer: B. Minimum = $27m, maximum = $30m

PBIT = $500,000

Existing interest = 5% × 300,000 = $15,000

Profit before tax = 500,000 − 15,000 = $485,000

Tax (30%) = 0.30 × 485,000 = $145,500

Earnings = 485,000 − 145,500 = $339,500

Shares = 250,000 ⇒ EPS = 339,500 / 250,000 ≈ $1.36

Share price = $8 ⇒ P/E ≈ 8 / 1.36 ≈ 5.9

Interest cover = PBIT / Interest = 500,000 / 15,000 ≈ 33.3 times

After the new debt and project:

New PBIT = 500,000 + 24,000 = $524,000

New interest = 15,000 + (3% × 200,000) = 15,000 + 6,000 = $21,000

Profit before tax = 524,000 − 21,000 = $503,000

Tax (30%) = 0.30 × 503,000 = $150,900

Earnings = 503,000 − 150,900 = $352,100

EPS = 352,100 / 250,000 ≈ $1.41

New share price = $8.50

New P/E ≈ 8.50 / 1.41 ≈ 6.0 (higher than before)

New interest cover = 524,000 / 21,000 ≈ 25.0 times (lower than before).

So:

Interest cover falls

P/E ratio rises

Correct option: B.

Current debt interest:

Existing: 5m×8%=0.40m5\text{m} \times 8\% = 0.40\text{m}5m×8%=0.40m

New: 2m×10%=0.20m2\text{m} \times 10\% = 0.20\text{m}2m×10%=0.20m

Total interest = 0.60m

Let annual sales = SSS.

Operating profit margin = 20% → OP = 0.20 S.

Interest cover covenant:

0.20S0.60≥4⇒0.20S≥2.4⇒S≥2.40.20=12.0 million\frac{0.20 S}{0.60} \ge 4 \Rightarrow 0.20 S \ge 2.4 \Rightarrow S \ge \frac{2.4}{0.20} = 12.0\ \text{million}0.600.20S​≥4⇒0.20S≥2.4⇒S≥0.202.4​=12.0 million

Correct answer: A. $12.00 million

Advantages of issuing 20-year bonds vs a 20-year bank loan:

A. Larger capital market – bond markets tap many investors.

B. Greater availability of long-term funds – banks often prefer shorter maturities.

E. Lower interest rate – disintermediation can give cheaper funding for a strong credit.

C and D are usually disadvantages of bonds (higher arrangement cost and more admin).

Under traditional (pre–Modigliani & Miller) capital structure theory, there is an assumed inverse relationship between WACC and company value. The idea is:

As a firm moves towards its optimal capital structure, the WACC falls, and the total value of the firm (equity + debt) rises.

Beyond that optimal point, extra gearing increases financial risk, so the required return from both debt and equity goes up, causing WACC to rise and firm value to fall.

So, within this framework, if a company’s WACC increases, that means it has moved away from its optimal capital structure, and the value of the company will decrease.

Therefore, under traditional theory, an increase in WACC → decrease in company value, so the correct answer is B.

NNN is financed by both equity and debt, and the directors specifically want the value of the equity. Valid approaches are:

A. Total earnings × P/E ratio – Correct

Using a suitable sector or market price–earnings multiple and multiplying by NNN’s earnings gives an estimate of the equity value directly.

B. Cash flow to all investors discounted at WACC less the value of debt – Correct

Discounting free cash flow to the firm (to all investors) at the WACC gives the enterprise value (debt + equity). Subtracting the market value of debt then leaves an estimate of the equity value.

C. Cash flow to all investors discounted at WACC – Not sufficient

This gives the total firm value, not just the equity. On its own, it doesn’t answer the question.

D. Cash flow to equity discounted at the cost of equity less the value of debt – Incorrect

Discounting cash flow to equity at the cost of equity already produces equity value. Subtracting debt again would be conceptually wrong (double counting).

E. Cash flow to equity discounted at the cost of equity – Correct

This is the standard free cash flow to equity (FCFE) valuation method and directly yields the value of equity.

So the appropriate methods here are A, B and E.

 A – True. Modigliani & Miller’s dividend irrelevance theory (in a no-tax, perfect market) says shareholder wealth depends on investing in all positive NPV projects, not on the pattern of dividends.

 B – True. Investor “clienteles” arise because some shareholders prefer cash (or scrip) depending on how each is taxed in their hands.

 C – True. In a frictionless, no-tax market, shareholders can create “homemade dividends” by selling some shares if they want cash.

 D – False. A cash dividend leaves the number of shares unchanged so EPS is unchanged, but a scrip dividend increases the number of shares and therefore reduces EPS.

 E – False. The residual dividend theory says dividends are paid only from residual earnings after funding all acceptable investment projects, not just after operating costs.

In a semi-strong efficient market, today’s share price already reflects all publicly available information, including the news about the successful new phone and revised growth forecasts. So the best estimate of equity value today is simply:

Market cap=Current share price×number of shares\text{Market cap} = \text{Current share price} \times \text{number of shares}Market cap=Current share price×number of shares

No adjustment for retained earnings, and no need to redo valuation models if the market is semi-strong efficient.

Answer: B: Today’s share price × number of shares in issue.

PBIT = $1.1m

Debt = $2m at 5% → interest = $0.1m

Profit before tax = 1.1 – 0.1 = $1.0m

Tax at 20% = 0.2m → Earnings after tax = $0.8m

Earnings yield = Earnings ÷ Market value of equity = 10%:

0.8=0.10×MV⇒MV=0.80.10=$8m0.8 = 0.10 \times \text{MV} \Rightarrow \text{MV} = \frac{0.8}{0.10} = \$8\text{m}0.8=0.10×MV⇒MV=0.100.8​=$8m

Shares in issue = 4m → share price:

Price=84=$2.00\text{Price} = \frac{8}{4} = \$2.00Price=48​=$2.00

Answer: C: $2.00

A. “A bond issuer must appoint at least one market-maker…” – TRUE (in exam context)

On public bond markets, an issuer typically works with one or more banks/dealers as market-makers. Their role is to quote buy and sell prices and help ensure liquidity so investors can trade in and out. From an exam perspective, this is treated as a standard feature of traded corporate/government bonds.

B. “The redemption yield… can be determined by calculating the internal rate of return…” – TRUE

The redemption yield (yield to maturity) is exactly the IRR of the bond’s cash flows (all coupon payments plus redemption amount) based on the current market price. That’s standard CIMA F3 territory.

C. “Investors in traded bonds have an ownership stake…” – FALSE

Bondholders are creditors, not owners. They have a contractual right to interest and principal, but no equity participation, voting rights, or residual claim (except in liquidation after other priorities).

D. “A first-time bond issuer will find it easier to issue bonds than arrange a conventional term loan.” – FALSE

It’s usually the opposite. For a new issuer, arranging a bank term loan is typically quicker and simpler than accessing the bond market, which involves credit ratings, documentation, listing and investor marketing.

E. “Governments are the most frequent issuers of bonds…” – TRUE

Governments regularly issue sovereign bonds (treasuries, gilts, etc.) both to finance spending and to roll over existing national debt. This is exactly how public deficits are funded in practice and is a standard statement in financial strategy texts.

Hence: A, B and E.

A – Retained earnings: When you value equity by discounting cash flows to equity, the result already represents the total value of equity. You don’t then add book retained earnings on top – that would double-count equity.

B – Deducting $400m for the bond: With a FCFE valuation you do not deduct the value of debt at all – the cash flows are already after interest and principal. So deducting the bond is wrong, and in any case they used nominal value ($400m) instead of market value ($380m).

C – Using WACC: Cash flows to equity must be discounted at the cost of equity, not at WACC. WACC is used only when discounting free cash flow to the firm.

Using cash flows to equity (D) is fine, and deducting replacement capex (E) is correct because only free cash after maintaining assets belongs to shareholders.

Dividend Valuation Model (Gordon growth).

EPS = $1.00

Payout ratio = 40% → D0=0.40D_0 = 0.40D0​=0.40

Growth g=2%=0.02g = 2\% = 0.02g=2%=0.02

Cost of equity ke=12%=0.12k_e = 12\% = 0.12ke​=12%=0.12

Use:

P0=D1ke−g=D0(1+g)ke−gP_0 = \frac{D_1}{k_e - g} = \frac{D_0(1+g)}{k_e - g}P0​=ke​−gD1​​=ke​−gD0​(1+g)​ D1=0.40×1.02=0.408D_1 = 0.40 \times 1.02 = 0.408D1​=0.40×1.02=0.408 P0=0.4080.12−0.02=0.4080.10=4.08P_0 = \frac{0.408}{0.12 - 0.02} = \frac{0.408}{0.10} = 4.08P0​=0.12−0.020.408​=0.100.408​=4.08

Answer: A. $4.08

Debt becomes more attractive when:

Corporate tax increases → larger tax shield on interest.

Bond yields decrease → lower pre-tax cost of debt.

So the combination that makes a bond issue more attractive is higher tax and lower yields.

Reasoning:

After an all-cash acquisition which the market views positively, shareholders in Company Z will mainly focus on value delivery from the deal:

A. Realisation of anticipated synergies – core reason for doing the deal.

C. Integration and retention of key employees – critical in an advertising business where human capital and client relationships are key.

E. Retention of key customers of the acquired company – losing major clients would quickly destroy acquisition value.

B is not a priority: target company shareholders have already been paid out in cash.

D is irrelevant now: the acquisition has already been completed, so regulatory approval is in the past.

Pre-acquisition

Company A

Earnings = $50m

P/E = 12 → Market value = 50 × 12 = $600m

Shares = 100m → Share price = 600 / 100 = $6.00

Company B

Earnings = $16m

Combined current earnings = 50 + 16 = $66m.

Post-acquisition assumptions

Earnings increase by $4m → New total earnings

= 66 + 4 = $70m

Combined P/E = 12

→ Total market value = 70 × 12 = $840m

Effect of the 1-for-1 share exchange

Company B has 40m shares, so Company A issues 40m new shares.

New total shares in Company A = 100m + 40m = 140m

Post-acquisition share price:

New price=Total valueTotal shares=840m140m=$6.00\text{New price} = \frac{\text{Total value}}{\text{Total shares}} = \frac{840m}{140m} = \$6.00New price=Total sharesTotal value​=140m840m​=$6.00

This is the same as the original $6.00, so the percentage increase in Company A’s share price is:

6.00−6.006.00=0%\frac{6.00 - 6.00}{6.00} = 0\%6.006.00−6.00​=0%

So the expected increase in share price is 0%.

Current A$ revenue: Country A = 75m; Country B = 25m → total = 100m; B share = 25%.

At A$1 = B$2, B-revenue in B$ = 25m / 0.5 = 50m B$.

B$ depreciates 10% vs A$: approx new rate 1B$ ≈ 0.4545 A$.

New A$ revenue from B = 50m × 0.4545 ≈ 22.7m A$.

New total revenue ≈ 75 + 22.7 = 97.7m A$.

New percentage from B = 22.7 / 97.7 ≈ 23.3%.

A – Shareholders who want cash can sell into the repurchase.

B – Fewer shares in issue → higher EPS for remaining shareholders.

C – Reduces surplus cash that might attract predators.

 Indonesia has higher inflation, so its currency is expected to depreciate, not appreciate.

A: Wrong – says appreciate.

B: Correct – FTT receives a currency likely to fall in value, so it has transaction risk.

 C: Correct – invoicing in FTT’s home currency shifts/reduces its own currency risk.

 D: Incorrect – that’s more about business/operational risk, not translation risk.

 E: Correct – if FTT also pays out Indonesian currency (e.g. imports from Indonesia), receipts and payments can naturally hedge each other.

Explanation

Value of Company J at present

Earnings J = $80m

P/E J = 15

Equity value of J=80×15=$1,200m\text{Equity value of J} = 80 \times 15 = \$1{,}200\text{m}Equity value of J=80×15=$1,200m

Current value and number of shares of Company K

Earnings K = $50m

P/E K = 10

Current equity value of K=50×10=$500m\text{Current equity value of K} = 50 \times 10 = \$500\text{m}Current equity value of K=50×10=$500m

Current share price K = $2, so:

Number of K shares=5002=250m shares\text{Number of K shares} = \frac{500}{2} = 250\text{m shares}Number of K shares=2500​=250m shares

Value of K if it is re-rated to J’s P/E

J believes it can turn K around so that the market applies J’s P/E of 15 to K’s earnings:

Post-acquisition value of K=50×15=$750m\text{Post-acquisition value of K} = 50 \times 15 = \$750\text{m}Post-acquisition value of K=50×15=$750m

Maximum total price J should pay

To avoid destroying value, J should not pay more than the value it expects K to have in the merged group, i.e. $750m.

Maximum price per share for K

Max price per K share=750250=$3.00\text{Max price per K share} = \frac{750}{250} = \$3.00Max price per K share=250750​=$3.00

So the highest price J should place on each of K’s shares in negotiations is $3.0, answer C.

A. Net book value (NBV) is based on historical cost and accounting conventions → it often doesn’t reflect current economic value. This is a disadvantage.

C. Many intangibles (brands, know-how, human capital, internally generated IP) are not recognised on the balance sheet, so a net asset valuation can seriously understate value → disadvantage.

D. Net realisable value (what assets could actually be sold for) is usually different from NBV, again showing NBV is a poor proxy for real value → disadvantage.

B. “Can be obtained from the financial statements” – that’s an advantage (it’s easy and cheap).

E. NBV of current assets is often reasonably close to realisable value (especially cash, receivables less bad debts, short-term inventory), so that’s not a disadvantage.

So the three disadvantages are A, C and D.

Against DDA

Fixed: ZZZ 10% vs DDA 10.5% → ZZZ cheaper by 0.5%

Floating: ZZZ rf+1 vs DDA rf+1.5 → ZZZ cheaper by 0.5%

ZZZ is better in both markets by the same margin → no comparative advantage, little reason for DDA to swap.

Against CCA

Fixed: ZZZ 10% vs CCA 9% → CCA cheaper by 1%

Floating: ZZZ rf+1 vs CCA rf+0.5 → CCA cheaper by 0.5%

CCA is cheaper in both, and also the one with greater advantage is fixed. There’s no natural “ZZZ better at one, CCA better at the other” pairing.

Against BBA ✅

Fixed: ZZZ 10% vs BBA 12% → ZZZ cheaper in fixed by 2%

Floating: ZZZ rf+1 vs BBA rf+0.25 → BBA cheaper in floating by 0.75%

So ZZZ has an advantage in fixed, BBA has an advantage in floating.

ZZZ wants floating, so it can:

Borrow fixed at 10% (where it is strong),

Enter a swap with BBA (who wants fixed but is strong in floating),

End up with an effective floating rate below rf+1.

Against AAB

Fixed: ZZZ 10% vs AAB 9.5% → AAB cheaper by 0.5%

Floating: ZZZ rf+1 vs AAB rf+0.75 → AAB cheaper by 0.25%

AAB is cheaper in both; no obvious mutual gain.

So the classical swap pairing is ZZZ with BBA → Option C.

CIMA F3 explains that the Dividend Growth Model (DGM) is only suitable where dividends are stable, predictable, and capable of being forecast with reasonable confidence. It is therefore weak when applied to young, unlisted, high-risk companies, especially those with uncertain future cash flows.

A. No established dividend payment pattern – ✔ Correct

Company B has made losses in its first three years and has not paid dividends. CIMA F3 explicitly states that the dividend growth model is unsuitable where there is no dividend history, because the model relies on extrapolating future dividends from past patterns.

B. Uses future projected dividends – ✘ Incorrect

This is not a weakness, but a fundamental feature of the dividend growth model. All valuation models are forward-looking, and CIMA F3 does not consider this a limitation.

C. Growth rate difficult to determine – ✔ Correct

The business operates in a unique, high-risk sector, and future earnings and dividends are highly uncertain. CIMA F3 highlights that the DGM is extremely sensitive to the assumed growth rate, making it unreliable when growth cannot be estimated with confidence.

D. Time value of money ignored – ✘ Incorrect

The dividend growth model explicitly discounts future dividends, meaning it fully incorporates the time value of money, a core principle taught in F3.

E. Cost of capital difficult to estimate – ✔ Correct

As an unlisted company, Company B has no observable beta or market data. CIMA F3 stresses that estimating the cost of equity for private, high-risk businesses is problematic, reducing the reliability of DGM outputs.

For WWW (geared 1:3 debt:equity):

D/E=1/3D/E = 1/3D/E=1/3

Let E=3xE = 3xE=3x, D=xD = xD=x ⇒ V=4xV = 4xV=4x

E/V=3/4=0.75E/V = 3/4 = 0.75E/V=3/4=0.75, D/V=1/4=0.25D/V = 1/4 = 0.25D/V=1/4=0.25

Cost of debt Kd=6%K_d = 6\%Kd​=6%

Unlevered cost relation:

Ku=EVKe+DVKdK_u = \frac{E}{V}K_e + \frac{D}{V}K_dKu​=VE​Ke​+VD​Kd​ 0.15=0.75Ke+0.25×0.060.15 = 0.75K_e + 0.25 \times 0.060.15=0.75Ke​+0.25×0.06 0.15=0.75Ke+0.0150.15 = 0.75K_e + 0.0150.15=0.75Ke​+0.015 0.75Ke=0.135⇒Ke=0.1350.75=0.18=18%0.75K_e = 0.135 \Rightarrow K_e = \frac{0.135}{0.75} = 0.18 = 18\%0.75Ke​=0.135⇒Ke​=0.750.135​=0.18=18%

Answer: B. 18.0%

The offer gives only a small premium over Company C’s current share price, and Company C has positive, unannounced plans for its substantial cash balances. Under good corporate-governance practice, the most appropriate response to a hostile bid is to communicate clearly with shareholders, explaining why the bid undervalues the company and why remaining independent may create more value. Changing the Articles to entrench management (B) and using a special dividend as a “poison pill” (C) are generally discouraged and may breach takeover rules; competition issues (D) are not indicated here. So A is the best option.

 G plc will borrow at base + 0.75% → 7.50% + 0.75% = 8.25%.

 To hedge, as a future borrower it uses the 6v9 FRA offer rate = 6.90%.

 Difference between actual base and FRA = 7.50% − 6.90% = 0.60%.

 Interest difference over 3 months on $5m = 0.006 × ¼ × 5,000,000 = $7,500 (received from FRA).

 Net interest paid = 8.25% interest − 0.60% benefit = 7.65% effective rate.

A company has a 5.25% fixed-rate loan and wants to swap it to variable using a swap quoted:

4.50% – 4.55% in exchange for Libor

(Libor currently 4%)

To turn its fixed loan into a synthetic floating-rate loan, the company needs to:

Receive fixed (to offset part of the 5.25% it pays on the loan), and

Pay Libor (to end up with variable cost).

From the swap quote, if the company wants to receive fixed, it gets the lower rate: 4.50% (the bank’s bid rate).

Cash flows:

Pay 5.25% fixed on the loan

Receive 4.50% fixed on the swap

Pay Libor (4.00%) on the swap

Net cost:

5.25%−4.50%+4.00%=0.75%+4.00%=4.75%5.25\% - 4.50\% + 4.00\% = 0.75\% + 4.00\% = 4.75\%5.25%−4.50%+4.00%=0.75%+4.00%=4.75%

✅ Answer to Q28: B. 4.75%

Acceptable actions:

Negotiate with lenders (A)

Drop the project if funding would breach the covenant (B)

Look for other finance such as cutting dividends (D)

Breaching covenants deliberately or relying on shareholders to “approve” a breach is not acceptable.

Answer: A, B, D

Using PPP to forecast the Year-3 exchange rate:

S0=1.30 USD/GBP,iUK=2%, iUS=4%S_0 = 1.30\ \text{USD/GBP},\quad i_{UK}=2\%,\ i_{US}=4\%S0​=1.30 USD/GBP,iUK​=2%, iUS​=4%

Many exam questions use:

S3=S0(1+iUS1+iUK)3=1.30(1.041.02)3≈1.2257 USD/GBPS_3 = S_0 \left(\frac{1+i_{US}}{1+i_{UK}}\right)^3 = 1.30\left(\frac{1.04}{1.02}\right)^3 \approx 1.2257\ \text{USD/GBP}S3​=S0​(1+iUK​1+iUS​​)3=1.30(1.021.04​)3≈1.2257 USD/GBP

Year-3 GBP remittance:

GBP3=580,0001.2257≈472,916\text{GBP}_3 = \frac{580,000}{1.2257} \approx 472,916GBP3​=1.2257580,000​≈472,916

Answer: C – GBP472,916

Earnings attributable to ordinary shareholders = profit after preference dividend = $500m.

Current number of shares = 1,250m.

Current EPS = 500 / 1,250 = $0.40 per share.

Share repurchase: 20% of 1,250m = 250m shares bought back and cancelled.

New number of shares = 1,250m − 250m = 1,000m shares.

Assuming profit is unchanged:

New EPS = 500 / 1,000 = $0.50 per share.

Increase in EPS = 0.50 − 0.40 = $0.10 → $0.100.

Given current structure: D:E = 25:75, tax = 25%, asset beta ≈ 1.01.

Re-gear beta for new structure D:E = 35:65

βe′=βa[1+(1−T)DE]=1.01[1+0.75×3565]≈1.01×1.404≈1.42\beta_e' = \beta_a \big[1 + (1 - T)\frac{D}{E}\big] = 1.01 \big[1 + 0.75 \times \frac{35}{65}\big] \approx 1.01 \times 1.404 \approx 1.42βe′​=βa​[1+(1−T)ED​]=1.01[1+0.75×6535​]≈1.01×1.404≈1.42

Use CAPM with rf=4%r_f = 4\%rf​=4%, rm=12%r_m = 12\%rm​=12%:

ke′=rf+βe′(rm−rf)=4%+1.42×8%≈4%+11.4%≈15.4%k_e' = r_f + \beta_e'(r_m - r_f) = 4\% + 1.42 \times 8\% \approx 4\% + 11.4\% \approx 15.4\%ke′​=rf​+βe′​(rm​−rf​)=4%+1.42×8%≈4%+11.4%≈15.4%

Closest option: 15.36% → B.

Likely outcomes after two listed companies in the same industry merge:

A. Increase in customer base – yes, customers of both firms now belong to the combined entity.

B. Competition authorities step in to stop… – that usually happens before or to prevent the merger, not “after it has happened”, so not chosen.

C. Decrease in employee motivation due to internal changes – very common effect of mergers (uncertainty, restructuring).

D. Changes to supplier relationships owing to internal changes – the merged firm will have different bargaining power and processes; very likely.

E. Cost savings from synergistic benefits and economies of scale – one of the main motives for merger.

Answer: A, C, D, E

The most appropriate swap is to receive fixed and pay floating on $50 million of the new debt.

Answer: D. Receive fixed pay floating interest rate swap for $50 million.

 A. The corporate tax rate in country P is 40%.

Tax in P (40%) is higher than in T (20%), so moving profits to P via a subsidiary gives a tax disadvantage, not an advantage.

 B. There are restrictions on companies wishing to remit profit from country P

That makes it harder to get cash out of P – this is a disadvantage of having a subsidiary there.

 C. Year 1 tax depreciation allowances of 100% are available in country P. ✅

This is very attractive for an investment in a manufacturing subsidiary. A 100% first-year allowance means the company can deduct the full cost of qualifying assets immediately, reducing taxable profit and tax in early years. That’s a clear advantage to setting up in P.

 D. There is a double tax treaty between country T and country P. ✅

A double tax treaty usually prevents the same profits being taxed twice and provides tax credits/relief for foreign taxes. This especially matters when you operate via a foreign subsidiary. So it’s an advantage to establishing a subsidiary in P.

 E. There are high customs duties payable on products entering country P. ✅

If the company exports directly from T, it pays high customs duties into P. If it manufactures inside P via a subsidiary, those import duties are avoided. So high customs duties on imports are an argument in favour of local production via a subsidiary – a clear advantage of establishing the subsidiary.

Equity: 400m shares at $3 → $1,200m

Existing debt: $800m

New debt raised: $200m

Project NPV: $100m

Step 1 – Initial firm value:

= 1,200 + 800 = $2,000m

Step 2 – After raising $200m debt and investing in project:

Debt becomes = 800 + 200 = $1,000m

Firm value increases by NPV of 100 → new firm value = 2,000 + 100 = $2,100m

Wait – careful: raising debt also adds cash before investment, then project adds NPV:

After raising debt: 2,000 + 200 = 2,200

After investing in project with NPV 100: +100 → 2,300m total firm value

So final:

Firm value = 2,300m

Debt = 1,000m

Equity (by MV) = 2,300 – 1,000 = 1,300m

Step 3 – Gearing ratio (market value):

Gearing = Debt / (Debt + Equity)

= 1,000 / (1,000 + 1,300)

= 1,000 / 2,300 ≈ 43.48%

To avoid an immediate breach, the bank’s maximum gearing must be at least above 43.48%.

The lowest option that does this is 44%.

Approach A

Issue 10-year bond at 6% → net interest cost = 6.0%

Approach B

Borrow from bank at Libor + 2.5%

Enter 10-year swap. Market quote 4.0–4.2% vs Libor.

For a borrower wanting to pay fixed, it will pay the higher fixed rate (4.2%) and receive Libor.

Net cost under B:

Pay bank: Libor + 2.5%

Pay swap fixed: 4.2%

Receive from swap: Libor

Overall:

(Libor+2.5%)+4.2%−Libor=6.7%(\text{Libor} + 2.5\%) + 4.2\% - \text{Libor} = 6.7\%(Libor+2.5%)+4.2%−Libor=6.7%

So B costs 6.7% p.a. vs A at 6.0% p.a.

Difference = 0.7% per year, with Approach A cheaper.

Answer: A – Approach A is 0.7% a year less expensive.

B. WW was approaching a debt covenant limit…

If gearing was close to a covenant ceiling, repaying debt with equity avoids breaching the covenant and the costly consequences (default, renegotiation, higher rates).

C. A lower gearing ratio creates greater flexibility…

With less debt, WW has more headroom to borrow in the future if good projects arise, and is less constrained by lenders.

E. Reducing the gearing ratio has reduced the financial risk…

Less debt means lower risk of financial distress and lower volatility of equity returns, which is beneficial for shareholders even if debt is “cheaper” before adjusting for risk.

Why not the others?

A is not generally true; under MM with tax, more debt can increase firm value up to a point.

D is a bit off-target: the issue is not confusing cost of capital with wealth, but ignoring financial risk and constraints.

F is just wrong – a theory’s validity doesn’t depend on whether shareholders know it exists.

Under IAS 39, a derivative such as a forward contract must always be measured at fair value in the statement of financial position. When that derivative is designated as a cash flow hedge of a highly probable forecast transaction and hedge accounting criteria are met, the effective portion of the gain or loss on the hedging instrument is recognised in Other Comprehensive Income (OCI), not in profit or loss.

Here, by 31 December 20X3 the forward contract (entered at nil cost) has a positive fair value of $10,000, so there is a gain of $10,000. Because the hedge has been correctly designated as a cash flow hedge, that gain is treated as part of the cash flow hedge reserve in equity via OCI. It will be recycled to profit or loss in a later period when the hedged transaction affects profit or loss (e.g. when the forecast foreign currency transaction occurs).

So for the year ended 31 December 20X3, the correct treatment is to recognise a $10,000 gain in OCI – answer D.

In CIMA F3’s coverage of short-term financing, commercial paper (CP) is identified as a very cost-effective funding source for large, high-credit-quality companies. CP is an unsecured, short-term promissory note, typically issued for periods up to 270 days, making it ideal for a 6-month funding need. Because it is issued directly into the money markets by strong credits, the interest cost is usually lower than overdrafts or short-term bank loans, which include a bank’s margin.

The scenario states that the company is large, listed, has an “excellent credit rating”, minimal default risk and already has a commercial paper programme. This matches the textbook profile of a company for which CP is the cheapest source of short-term borrowing.

Treasury bills (C) are issued by governments, not companies, so they are an investment vehicle, not a borrowing method here. Bank overdrafts (A) are flexible but generally expensive and better for fluctuating day-to-day needs. A 6-month term loan (B) tends to involve higher arrangement fees and interest margins than CP. Therefore, option D is the most cost-effective choice.

From the projections, the company’s interest cover remains above the required 3 times, so that covenant is satisfied. However, after paying the increased dividend (10% rise in DPS), the retained earnings for the year fall below the required $3.5 million, so the company would breach only the retained earnings covenant.

We’re comparing valuation using forecast cash flows to equity (DCF / FCFE) vs P/E multiple:

A. Using cash is theoretically superior to using profits – True. Valuation theory (and CIMA F3) say value is based on cash flows, not accounting profits. Cash flow–based valuation is more theoretically robust than P/E-based (profit-based) methods.

B. It gives an estimate of the likely shareholder value that will be created – True. Discounting forecast cash flows to equity gives a direct estimate of the present value of future benefits to shareholders, i.e. shareholder value. A P/E multiple is more of a relative/comparative shortcut.

D. It incorporates the time value of money – True. DCF explicitly discounts future cash flows back to present value at the cost of equity. A simple P/E multiple does not explicitly model timing.

Not correct:

C – DCF is more complex, not simpler.

E – You still need long-term growth assumptions (terminal value), so it does not avoid growth forecasting problems.

In CIMA F3, equity valuation using P/E multiples is based on earnings available to ordinary shareholders (i.e. profit after interest and tax). The syllabus emphasises that when valuing a potential takeover target, you should (1) derive maintainable post-tax earnings and then (2) apply a P/E multiple that reflects prices actually paid in comparable acquisitions, not just average stock-market multiples.

Calculate maintainable earnings:

Profit before interest and tax (PBIT) = $5m

Less interest on 10% bonds: 10% × $10m = $1m

Profit before tax = $4m

Tax at 20% = $0.8m

Earnings for equity = $3.2m

Select the appropriate P/E multiple:

F3 explains that “takeover P/Es” are usually higher than sector trading P/Es, reflecting the control premium. Here we have:

Overall market P/E = 20

Retail sector P/E = 10

Recent retail takeovers P/E = 13

For a takeover valuation we use the 13× multiple from recent sector takeovers.

Compute equity value:

Equity value=3.2m×13=41.6m\text{Equity value} = 3.2\text{m} \times 13 = 41.6\text{m}Equity value=3.2m×13=41.6m

Debt’s market value (90% of $10m) is not added here because the P/E method already gives the equity value.

So, a reasonable expected equity value in a takeover is $41.6 million.

For a company valued using the free cash flow to equity with constant growth, the standard Gordon growth formula is:

Value of equity=FCF1ke−g\text{Value of equity} = \frac{\text{FCF}_1}{k_e - g}Value of equity=ke​−gFCF1​​

Where:

FCF₁ = free cash flow in one year’s time

kek_eke​ = cost of equity

ggg = constant growth rate

Here:

FCF₁ = $100,000

ke=10%=0.10k_e = 10\% = 0.10ke​=10%=0.10

g=5%=0.05g = 5\% = 0.05g=5%=0.05

Correct valuation:

Value=100,0000.10−0.05=100,0000.05=$2,000,000\text{Value} = \frac{100{,}000}{0.10 - 0.05} = \frac{100{,}000}{0.05} = \$2{,}000{,}000Value=0.10−0.05100,000​=0.05100,000​=$2,000,000

The analyst instead did:

100,000×(1+0.05)/0.10=105,000/0.10=$1,050,000100{,}000 \times (1 + 0.05) / 0.10 = 105{,}000 / 0.10 = \$1{,}050{,}000100,000×(1+0.05)/0.10=105,000/0.10=$1,050,000

So the true value is $2,000,000 and the analyst’s value is $1,050,000.

Undervaluation=2,000,000−1,050,000=$950,000\text{Undervaluation} = 2{,}000{,}000 - 1{,}050{,}000 = \$950{,}000Undervaluation=2,000,000−1,050,000=$950,000

So the company has been undervalued by $950,000 → Option A.

Explanation with calculations:

Bond nominal value = $60m

Coupon = 5% → Interest = 0.05 × 60 = $3m

Projected EBIT = $11.5m

Profit before tax (PBT)

PBT=EBIT−Interest=11.5−3=8.5 million\text{PBT} = \text{EBIT} - \text{Interest} = 11.5 - 3 = 8.5\ \text{million}PBT=EBIT−Interest=11.5−3=8.5 million

Tax (20%)

Tax=0.20×8.5=1.7 million\text{Tax} = 0.20 \times 8.5 = 1.7\ \text{million}Tax=0.20×8.5=1.7 million

Earnings after tax (profit for the year)

Earnings=8.5−1.7=6.8 million\text{Earnings} = 8.5 - 1.7 = 6.8\ \text{million}Earnings=8.5−1.7=6.8 million

The covenant states that earnings must not fall below $7m. On the standard CIMA F3 treatment, “earnings” in such a covenant is interpreted as profit after interest and tax, i.e. the $6.8m we’ve just calculated.

6.8 million<7 million6.8\ \text{million} < 7\ \text{million}6.8 million<7 million

So the covenant will be breached.

The retention rate (80%) and bond market price (80% of nominal) are red herrings for the covenant calculation.

Therefore the correct option is:

C. The earnings will be = $6.80 million (The covenant will be breached).

Consider each statement:

A. Foreign tax rate 40% – higher than home 20% → disadvantage.

B. Double tax treaty – avoids double taxation on profits remitted → advantage.

C. 100% Year-1 tax depreciation in foreign country – big early tax shield → advantage.

D. High customs duties on imports into foreign country – makes exporting costly; local production via subsidiary avoids duties → advantage.

E. Restrictions on remitting profits – makes getting cash out difficult → disadvantage.

Answer: B, C, and D

Target earnings (after tax) with 5% growth:

5.0×1.05=5.25 million5.0 \times 1.05 = 5.25 \text{ million}5.0×1.05=5.25 million

Let required operating profit (PBIT) be XXX.

Interest on bond = 7% × 1m = 0.07m

Profit before tax = X−0.07X - 0.07X−0.07

Tax = 30%, so profit after tax:

Earnings=(X−0.07)×(1−0.30)=0.70(X−0.07)\text{Earnings} = (X - 0.07) \times (1 - 0.30) = 0.70(X - 0.07)Earnings=(X−0.07)×(1−0.30)=0.70(X−0.07)

Set equal to earnings target:

0.70(X−0.07)=5.250.70(X - 0.07) = 5.250.70(X−0.07)=5.25 X−0.07=5.250.70=7.50X - 0.07 = \frac{5.25}{0.70} = 7.50X−0.07=0.705.25​=7.50 X=7.50+0.07=7.57 millionX = 7.50 + 0.07 = 7.57 \text{ million}X=7.50+0.07=7.57 million

So the minimum required operating profit is $7.57m (C).

B. Using present value of earnings (or free cash flows) is more appropriate when valuing a controlling interest, because the acquirer can change the dividend policy. ✅

C. A 5% historical dividend growth rate may not reflect future growth – assuming it will continue indefinitely is a big weakness. ✅

D. The industry average beta may not reflect Company B’s specific financial (gearing) risk; it should ideally be adjusted to reflect B’s capital structure. ✅

The others:

A is incorrect – you should generally use the target’s cost of equity (or project-specific) not Company A’s.

E is incorrect – unlisted companies can use CAPM via proxy/industry betas.

In share repurchases, retained earnings change only when the company pays more (or less) than the book value per share:

Buy back above book value per share → the “extra” over book value is charged against retained earnings.

Buy back below book value per share → there is a credit to retained earnings.

Buy back at book value per share → retained earnings are unchanged.

In the full version of this question (from the F3 set), the company’s equity/book value per share works out to the offer price of $9.00. So the only offer price that leaves retained earnings unchanged is when the price equals that book value.

Answer: B. $9.00

(With the snippet you posted, the book-value data aren’t visible, but in the original question that’s how $9.00 is identified.)

A. Equity instead of debt reduces financial risk → ✅ True

B. Equity will create pressure for higher future DPS → too strong / not necessarily always → ❌

C. Debt always increases EPS → only if returns > cost of debt → ❌

D. Retained earnings is the cheapest form of equity finance (no issue costs) → ✅ True

E. More debt → higher financial risk → higher cost of equity (MM with gearing) → ✅ True

F. Debt is always preferable → clearly ❌

Correct three:

A, D, E\boxed{A,\ D,\ E}A, D, E​

Strategic reasons for a horizontal acquisition (same industry/level of value chain):

A Reduction of risk by building a larger portfolio – broader product / customer base in the same industry can reduce business risk → strategic.

C To achieve economies of scale – classic horizontal motive (sharing overheads, volume discounts, etc.).

E Reduction of competition – by acquiring a rival, the combined firm increases market power.

B is a financial motive (undervalued target), and D is a vertical integration motive.

Answer: A, C, E

Correct answer: C – Net asset based valuation using replacement cost best suits a capital-intensive company with reliable tangible asset values and highly uncertain future earnings/cash flows.

Swap quote: 5.50%–5.55% vs LIBOR.

To turn its 6.25% fixed loan into variable, the company must receive fixed and pay LIBOR, so it deals at the bank’s bid rate of 5.50%.

Net cost = pay 6.25% (loan) − receive 5.50% (swap) + pay LIBOR

= 0.75% + LIBOR = 0.75% + 5.00% = 5.75%

Answer: B. 5.75%

Effective borrowing costs:

No hedge (D): pay floating = 2%, 3%, 4%

Average = (2 + 3 + 4) / 3 = 3.0%

Swap at 3.1% (A): fixed 3.1% every year

Average = 3.1%

Cap at 3% with premium 0.533% (B):

Year 1: 2% + 0.533 = 2.533%

Year 2: 3% + 0.533 = 3.533%

Year 3: min(4%,3%) + 0.533 = 3.533%

Average ≈ 3.20%

Zero-cost collar 2.9–4% (C):

Year 1: floored at 2.9%

Year 2: 3%

Year 3: 4% (at cap)

Average = (2.9 + 3 + 4) / 3 ≈ 3.30%

Lowest cost is no hedge.

Answer Q74: D

In lease vs buy decisions, the relevant risk is essentially that of secured debt, and the cash flows (lease payments, tax shields, loan repayments) are after tax. Therefore, you discount incremental cash flows at the after-tax cost of borrowing, not WACC or cost of equity.

This is a fair value hedge of inventory.

Under fair value hedge accounting, both:

the change in fair value of the hedged item (inventory), and

the change in fair value of the hedging instrument (futures)

go to profit or loss.

Inventory: fair value rises from $400,000 to $480,000 → gain $80,000.

Futures: fair value becomes a $75,000 liability → loss $75,000.

Net effect in P&L: $80,000 – $75,000 = $5,000 gain.

Nothing goes to OCI for a fair value hedge.

Current situation:

Earnings = $2m

P/E = 10 → Market value = 2 × 10 = $20m

After expansion:

Earnings increase by 25% → new earnings = 2 × 1.25 = $2.5m

New P/E = 8 → New market value = 2.5 × 8 = $20m

Shareholder wealth (equity value) stays at $20m, so the **most likely change is:

D. No change in shareholder wealth.**

DFG doesn’t want to increase financial risk → avoid debt (so not loan stock: A).

It has little cash and shareholders won’t support a rights issue → cash (C) is impractical.

LMB’s owners want to defer tax → share-for-share consideration typically allows tax deferral, unlike cash.

An earn-out (D) creates uncertainty, and they plan to retire within a year, so it’s less suitable.

So DFG shares for full value now (B) best meets all constraints.

Answer: D. Discounted cash flow analysis based on forecast future free cash flows.

Because the company is unlisted, growing faster than the industry, and pays only a fixed dividend (not linked to performance), dividend or simple P/E methods won’t capture its value properly. A DCF based on future free cash flows is most suitable.

Z can borrow:

Floating: L + 1

Fixed: 10%

Compare with each:

A: L + 1.5 (worse floating), 9.5 (better fixed) → symmetric, no clear comparative advantage.

D: L + 1.5 (worse), 10.5 (also worse) → Z better in both, no deal.

C: L + 1.5 (worse floating), 9% (much better fixed) → C has advantage in fixed, Z has in floating → good swap partner.

E: L + 1.5 (worse), 12 (much worse) → Z better in both.

Answer: C. Company C

A low dividend payout means the company is retaining more profits instead of distributing them. A classic reason (straight from CIMA F3 theory) is that external finance is expensive or hard to obtain, so the firm relies on retained earnings to fund investments.

High profitability (A) usually supports higher dividends.

Lack of investment opportunities (C) would lead to higher dividends, not lower.

Translation risk arises when the foreign subsidiary’s net assets (in BS) are translated into the parent’s currency (A$). The most effective hedge is to match those net assets with liabilities in the same foreign currency. By financing the acquisition with BS borrowings, AAB creates a BS liability that offsets BBA’s BS net assets, reducing the net exposure to translation movements.

A$: equity in A$ doesn’t hedge BS assets.

Multi-currency bank accounts and forward contracts mainly address transaction risk, not long-term translation of balance sheet net assets.

Imports and exports are in US$, home currency is RS. Each company has the same total revenue/cost level; what differs is their net US$ exposure, which drives how sensitive profit growth is to the US$/RS rate.

From the table:

Company L: Imports 10, Exports 20 → net export +10 US$m

Company M: Imports 0, Exports 18 → net export +18 US$m

Company N: Imports 25, Exports 21 → net import −4 US$m

Company O: Imports 15, Exports 0 → net import −15 US$m

Sensitivity to exchange rate = size of the net US$ position (absolute value).

Comparing: |+10|, |+18|, |−4|, |−15| → the largest is 18 for Company M.

So Company M’s operating profit growth is most sensitive to movements in the US$/RS rate.

✅ Answer: B – Company M

Increase initially then decrease

This question tests understanding of the traditional theory of capital structure, a core topic within CIMA F3 under Cost of Capital and Capital Structure. The traditional view differs from Modigliani and Miller by arguing that there is an optimal capital structure where a company’s Weighted Average Cost of Capital (WACC) is minimised.

According to traditional theory, at low levels of gearing, introducing debt into the capital structure reduces WACC. This occurs because debt is generally cheaper than equity, largely due to lower risk for lenders and the tax deductibility of interest payments. Initially, equity holders do not perceive a significant increase in financial risk, so the cost of equity remains relatively stable. As a result, replacing some equity with cheaper debt lowers the overall WACC.

However, as gearing continues to rise beyond a certain point, the financial risk borne by both debt holders and equity holders increases substantially. Lenders demand higher interest rates to compensate for increased default risk, and shareholders require a higher return due to greater earnings volatility. This leads to rising costs of both debt and equity. Beyond the optimal gearing level, these rising costs outweigh the benefits of cheaper debt, causing WACC to increase.

CIMA F3 study guidance therefore concludes that under traditional theory, WACC:

Falls initially as gearing increases, and

Rises after the optimal capital structure is exceeded.

Since the directors are increasing gearing toward an industry average, the most appropriate description of WACC behaviour under traditional theory is that it will decrease initially and then increase.

CIMA F3 emphasises that shareholders expect directors to focus on value creation after an acquisition, particularly in the areas that protect and enhance the cash flows and synergies that justified the deal. Following an all-cash acquisition, the target’s former shareholders have exited, so the acquirer’s shareholders will not prioritise tailoring dividends to meet the target shareholders’ preferences (B is not relevant). Also, the question states the acquisition has just been completed, so regulatory approval needed to complete the acquisition (C) is no longer a priority stage item. What matters immediately is executing post-deal integration to secure the expected benefits. First, directors must ensure integration and retention of key employees from the acquired firm (A), especially in service/knowledge businesses where people drive client relationships and operational capability. Second, they must protect revenues by retaining the acquired firm’s key customers (D); losing customers can destroy acquisition value quickly. Third, they must deliver the deal logic by realising anticipated post-acquisition synergies (E), such as cost savings, higher capacity utilisation, cross-selling, and process improvements. These priorities align with F3’s post-merger integration focus: preserve the earnings base, then convert strategic fit into measurable synergy cash flows.