MOCK EXAM

FM
ACCA
FINANCIAL MANAGEMENT

Time allowed

3 hours and 15 minutes

This paper is divided into three sections:

Section A ‐ All 15 questions are compulsory and MUST be

attempted Section B ‐ All 15 questions are compulsory

and MUST be attempted Section C ‐ BOTH questions are

compulsory and MUST be attempted Formulae sheet,

present value and annuity tables are on pages 3, 4 and 5

Section A
Objective Test Questions
 There are 15 questions and 2 marks for each question;
 All questions should be attempted;
1– Plasma Co has a cash conversion cycle of 45 days. The inventory is kept for an average period of 20
days. The trade payables outstanding at the end of the period are $4,932 and the business has made
total credit purchases of $100,000.

Calculate the average trade receivable days.

A. 43 days
B. 37 days
C. 27 days
D. 25 days

2– Which of the following statements are a valid criticisms of return on Capital employed (ROCE) as a
performance measure?

A. It is improper if used to compare divisions with different level of Risk

B. It is improper if used to compare divisions with assets of same ages
C. It encourages over investment in new or replacement assets
D. Data to calculate is not easily obtained

3 – Last year Rose Company made profits before tax of $5,256,000. Tax amounted to $1,576,000. Rose
Co.’s Share Capital was $2,000,000 (2,000,000 shares of $1) and $4,000,000 12% preference shares.

What was the earnings per share (EPS) for the year?

A. $0.62
B. $1.60
C. $1.84
D. $2.38

4 – Which of the following statement is correct?

A. Rewarding manager by performance is in line with financial management objective.

B. Corporate governance practices include minimization of Risk
C. Separation of CEO and Chairman Roles is one of corporate governance practices.
D. Maximizing employee benefits is an example of financial management objective.
5 – Victoria Co has estimated that a project with an initial investment of $65,000 will generate the
following after tax cash inflows:

Year Cash flow

1 $20,000
2 $20,000
3 $10,000
4 $10,000
5 $10,000

What is the payback period of the investment?

A. 4.2 years
B. 4.5 years
C. 3.5 years
D. 5.3 years

6 – Which of the following statements are correct?

-Asset Beta is smaller than equity Beta as it excludes financial Risks

-Traditional view suggests an optimal cost of capital

-Pecking order theory suggests finance should be raised by debt first.

A. 1 &2 Only
B. 1 &3 Only
C. 2 &3 Only
D. 1 ,2 & 3

7– GNC Co. has a cost of equity of 12%. Its historical dividend per share were: 20x8 $0.055; 20x
9$0.0595; 20Y0 $0.0618. Dividends are expected to grow at the same rate. BY dividend valuation model,
what is the share price at the start of 20Y1?

A. 1.09
B. 1.55
C. 1.61
D. 1.67
8– Data co has 10% redeemable loan notes in issue trading at $90. The loan notes are redeemable at a 10%
premium in 5 years’ time. Corporate tax rate is 30%. What is the best estimate of the cost of these loan notes?

A. 8.5%
B. 9.5%
C. 10.5%
D. 11.5%

9 – According to creditor hierarchy list the following from high to low Risk

1. Preference share capital

2. Ordinary share capital
3. Bank loan with fixed charges
4. Account payable
A. 1,2,3,4
B. 2,1,3,4
C. 3,4,1,2
D. 2,1,4,3

10 – Which of the following statement is correct?

A. Replacement value is the value of a company if sold off piece meal.

B. Price earnings multiple is the inverse of earnings yield
C. Acquirer of majority shareholding prefers dividend growth model in valuation
D. Historical cost and future income are considered in net present value method.

11– A redeemable loan notes in HIC mature in 3 years’ time at a premium of 10%. HIC pays corporation
tax at a rate of 30%. What is the current market value of loan note if loan note holder require a 10%
return?

A. $89.03
B. $95.00
C. $96.54
D. $102.51

12– CY Co currently has 2 million shares in issue. The market value of each share is $1.50. The business
is about to announce 1 for 4 rights issue @ $1.30 each.

Assuming that the rights issue is fully subscribed, what will the theoretical ex-rights price following the
issue of the new shares?

A. $1.37
B. $1.62
C. $1.32
D. $1.46
13– MO Co which is financed by equity only. It has just paid dividend of $30m and earning retained
were 60%. Return on investments is 20% and the cost of equity is 22%. What is the market value of the
company (to nearest whole million)?

A. $150m
B. $136m
C. $153m
D. $336m

14 – Which of the following statements are correct?

1. Option contract premium is paid when it is exercised.

2. Future contract position can be closed before expiry
3. Forward contract is a binding agreement on a fixed rate for future transaction
A. 1 and 2 Only
B. 1 and 3 Only
C. 2 and 3 only
D. 1,2 and 3
15– The current spot rate for the US $ to the European € is $1.3: €1. Annual interest rate in the two
countries are 6% in the US, and 3% in the Europe. What is the 3 month forward rate (to 4 decimal
places) likely to be?

A. 1.2632
B. 1.2904
C. 1.3097
D. 1.3379
Section B
ALL15 questions are compulsory and MUST be attempted.

Each question is worth two marks.

The following scenario relates to questions 16 –20.
The directors of Finland Co are considering making an offer to buy 100% of the shares in Rose Co, a
competitor company. Extracts from the most recent financial statements of Ride Co are as follows:
Statement of profit or loss for the year ended 31 December 20X9
$000

Profit before tax 2,200

Tax @ 30% (660)

––––––
Profit after tax 1,540
––––––
Dividends declared 250
––––––
Statement of financial position at 31 December 20X9
Freehold land and buildings 8,500
Plant and machinery 5,800
Current assets 4,300
Share capital (50c ordinary shares) 500
Retained earnings 7,900
6% irredeemable debentures 8,000
Current liabilities 2,200

Additional information
A recent independent valuation of some of the company’s assets showed that the land and buildings were
worth $9.6m and the plant and machinery $3.2m. The current asset balance includes a receivable of
$0.2m from a company in liquidation and some inventory worth $0.4m less than its carrying value.
Some research into listed companies in the publishing industry shows the following:
Average PE ratio 11
Average dividend yield 3%

16– Calculate the total equity value of Rose Co at 31 December 20X9 using the net asset basis
(revalued).

A. $8,400,000
B. $6,300,000
C. $14,300,000
D. $6,900,000
17 – Which of the following statements is correct about valuation methods?

A. The net asset (revalued) method would tend to over value a business such as Rose.
B. The dividend valuation model is usually only used to value a minority interest.
C. Income based valuation methods, such as the PE ratio method, are particularly good for valuing minority
shareholdings.
D. When using the PE ratio method for valuing a private company with fewer internal controls, the PE ratio
of a similar public company could be used and adjusted upwards.

18– If the return required by the debt holders of Ride is 7.5%, calculate the market value of the
irredeemable debt. Show your answer to the nearest dollar.

A. $80.00
B. $125.00
C. $56.00
D. $87.50

19– Calculate the value per share of Rose Co at 31 December 20X9 using dividend yield method. Show
your answer to the nearest cent.

20– Finland Co is considering purchasing Rose and which of the following valuation is the maximum that
Finland Co. should pay for the acquisition?

A. Historical cost adjusted for general inflation

B. Economic value – Net present value of the projects
C. Piecemeal net realizable value
D. Cost of setting up an equivalent business

The following scenario relates to questions 21–25.

Alfa Co is based in a country whose currency is the dollar ($). The company expects to receive
€1,500,000 in 6 months' time from Fin Co, a foreign customer. The finance director of Alfa Co is
concerned that the euro (€) may depreciate against the dollar before the foreign customer makes
payment and she is looking at hedging the receipt. Alfa Co has in issue loan notes with a total nominal
value of $4m which can be redeemed in 10 years' time. The interest paid on the loan notes is at a
variable rate linked to LIBOR. The finance director of Alfa Co believes that interest rates may increase in
the near future. The spot exchange rate is €1.543 per $1. The domestic short-term interest rate is 2%
per year, while the foreign short-term interest rate is 5% per year.

21– What is the six-month forward exchange rate predicted by interest rate parity (to 3 decimal
places)?

22 – As regards the euro receipt, what is the primary nature of the risk faced by Alfa Co?

A. Transaction risk
B. Economic risk
C. Translation risk
D. Business risk
23 – Which of the following hedging methods will NOT be suitable for hedging the euro receipt?

A. Forward exchange contract

B. Money market hedge
C. Currency futures
D. Currency swap

24– Which of the following statements support the finance director's belief that the euro will
depreciate against the dollar?

Supports the director's Does not support the

belief director's belief

1 - The dollar inflation rate is greater than

the euro inflation rate
2 - The dollar nominal interest rate is less
than the euro nominal interest rate

25 – As regards the interest rate risk faced by Alfa Co, which of the following statements is correct?

A. In exchange for a premium, Herd Co could hedge its interest rate risk by buying interest rate
options.
B. Buying a floor will give Herd Co a hedge against interest rate increases.
C. Herd Co can hedge its interest rate risk by buying interest rate futures now in order to sell them
at a future date.
D. Taking out a variable rate overdraft will allow Herd Co to hedge the interest rate risk through
matching.

The following scenario relates to questions 26–30.

Norman Co. operates in an industry which has recently been deregulated as the Government seeks to
increase competition in the industry.

Norman Co plans to replace an existing machine and must choose between two machines. Machine 1
has an initial cost of $200,000 and will have a scrap value of $25,000 after 4 years. Machine 2 has an
initial cost of $225,000 and will have a scrap value of $50,000 after 3 years. Annual maintenance costs of
the two machines are as follows:

Year 1 2 3 4
Machine 1 ($ per year) 25,000 29,000 32,000 35,000

Machine 2 ($ per year) 15,000 20,000 25,000

Where relevant, all information relating to this project has already been adjusted to include expected
future inflation. Taxation and tax-allowable depreciation must be ignored in relation to Machine 1 and
Machine 2. Norman Co has a nominal before-tax weighted average cost of capital of 12% and a nominal
after-tax weighted average cost of capital of 7%.

26– In relation to Norman, which TWO of the following statements about competition and deregulation
are true?

A. Increased competition should encourage Norman Co to reduce costs.

B. Deregulation will lead to an increase in administrative and compliance costs for Norman Co.
C. Deregulation should mean an increase in economies of scale for Norman Co.
D. Deregulation could lead to a decrease in the quality of Norman Co's products.

27 – What is the equivalent annual cost of Machine 1?

A. $90,412
B. $68,646
C. $83,388
D. $70,609

28 – Which of the following are advantages of the internal rate of return (IRR)?

I. Take into account the time value of money

II. Assumes funds are re invested at the IRR
III. Considers the whole project.
A. 1 and 2 only
B. 1 and 3 only
C. 2 and 3 only
D. 1, 2 and 3

29 – Doubt has been cast over the accuracy of the Year 2 and Year 3 maintenance costs for Machine 2.
On further investigation it was found that the following potential cash flows are now predicted:

Year Cash flow Probability

$
2 18,000 0.3
2 25,000 0.7
3 23,000 0.2
3 24,000 0.35
3 30,000 0.45

What is the expected present value of the maintenance costs for Year 3 (to the nearest $)?

$
30– Norman Co is appraising a different project, with a positive NPV. It is concerned about the risk and
uncertainty associated with this other project.

Which of the following statements about risk, uncertainty and the project is true?

A. Sensitivity analysis takes into account the interrelationship between project variables.
B. Probability analysis can be used to assess the uncertainty associated with the project.
C. Uncertainty can be said to increase with project life, while risk increases with the variability of
returns.
D. A discount rate of 5% could be used to lessen the effect of later cash flows on the decision.

SECTION C
BOTH questions are compulsory and MUST be attempted
31 – Arwan Co is a medium-sized profitable company that manufactures engineering products.
Its stated objectives are to maximise shareholder wealth and to maintain an ethical approach to
the production and distribution of engineering products. It has in issue two million ordinary shares,
held as follows:

Number of shares

Pension funds 550,000

Insurance companies 250,000

Investment trusts 200,000

Unit trusts 100,000

Directors of Arwan 350,000

Other shareholders 550,000

––––––––––

2,000,000

––––––––––

The Managing Director of Arwan is considering two items that have been placed on the agenda of the
next Board Meeting:

(1) Complaint by institutional investors

A number of institutional investors complained at the recent Annual General Meeting of the
company that expenditure on environmentally-friendly and socially-responsible projects was at
too high a level, resulting in a less than acceptable increase in annual dividend payments.

They had warned that they would vote against the re-appointment of directors if matters had not
improved by the next Annual General Meeting.

(2) Proposal to increase manufacturing capacity

The directors of Arwan need to increase capacity in order to meet expected demand for a new
product, Product G, which is to be used in the manufacture of new-generation personal
computers. Product G cannot be manufactured on existing machines. The directors have identified
two machines which can manufacture Product G, each with a capacity of 60,000 units per year,
as follows:

Machine One

This machine will cost $238,850 and last for five years, at the end of which time it will have zero scrap
value. Maintenance costs will be $10,000 in the first year of operation, increasing by $3,000 per year for
each year of operation.

Machine Two

This machine will cost $215,000 and last for four years, at the end of which time it will have zero scrap
value. Maintenance costs will be $10,000 in the first year of operation, increasing by $5,000 per year for
each year of operation.

Arwan expects demand for Product G to be 30,000 units per year in the first year, and to
increase by a further 10,000 units per year in each subsequent year. Selling price is expected to be
$10·00 per unit and the marginal cost of production is expected to be $7·80 per unit.
Incremental fixed production overheads of $10,000 per year will be incurred. Selling price and
costs are all in current price terms.

Annual inflation rates are expected to be as follows:

Selling price of Product G: 4% per year

Marginal cost of production: 4% per year
Maintenance costs: 5% per year
Fixed production overheads: 6% per year
Other information
Arwan has a real cost of capital of 8% and uses a nominal (money) cost of capital of
11% in investment appraisal. The company pays tax one year in arrears at an annual rate of
30% and can claim capital allowances on a 25% reducing balance basis, with a balancing
allowance at the end of the life of the machines. The company depreciates fixed assets on a
straight-line basis over the life of the asset and has a target before-tax return on capital
employed (accounting rate of return) of 25%.

Required:

a) Calculate the net present value of the incremental cash flows arising from purchasing
Machine Two and advise on its acquisition. (16 marks)
b) Calculate the before-tax return on capital employed (accounting rate of return) of the
incremental cash flows arising from purchasing Machine Two based on the average
investment and comment on your findings. (4 marks)

(20 marks)

32 – Smith Co, a toy manufacturer, has 20 million ordinary shares in issue. The market value of each
ordinary share is $12.50. The company has also issued 8% bonds having a total nominal value of $15
million. The nominal value of each bond is $100 and the market value is $105. The bonds are to be
redeemed in 5 years’ time at the nominal value. The existing equity beta of Smith Co is 0.8.

The risk free rate of return in the market is 5% and the equity risk premium is 6%. The corporate
taxation rate is 30%.

Smith Co is now planning to enter the crockery manufacturing business. A similar business in the
crockery manufacturing is Gamma Co. Gamma Co has an equity beta of 1.3. The market value of the
equity issued by Gamma Co is $50 million and the market value of debt is $20 million.

The finance director has suggested using the book values of the equity and debt in the calculation of
weighted average cost of capital while evaluating the new project. She believes that this approach will
lower the weighted average cost of capital and will make the project more attractive.

Required:

(a) Calculate the current weighted average cost of capital of Smith Co. (9 marks)
(b) Calculate the cost of equity that Smith Co should use in evaluating the new project. (6 marks)
(c) Explain the difference between market value based weighted average cost of capital and book
value based weighted average cost of capital. Discuss which one is more suitable when
making investment decisions. (5 marks)

(20 marks)