ACA Business Finance 2 — Questions and Answers
Question 1: Net present value (NPV) is considered superior to the payback period method because:
- It is simpler to calculate
- It considers the time value of money and all cash flows over the project's life (Correct answer)
- It does not require a cost of capital
- It is preferred by HMRC
Correct answer: It considers the time value of money and all cash flows over the project's life
NPV accounts for the time value of money by discounting all cash flows, considers the full life of the project, and measures value creation in absolute monetary terms.
Question 2: The dividend growth model values a share as:
- Current dividend divided by cost of equity
- Next year's expected dividend divided by (cost of equity minus growth rate) (Correct answer)
- Earnings per share divided by the P/E ratio
- Book value of equity divided by shares outstanding
Correct answer: Next year's expected dividend divided by (cost of equity minus growth rate)
The Gordon Growth Model (dividend growth model) calculates share price as D1 / (Ke - g), where D1 is the next dividend, Ke is the required return, and g is the constant growth rate.
Question 3: Financial gearing measures:
- The proportion of equity in the capital structure
- The ratio of debt to equity (or total capital) (Correct answer)
- The ability to pay dividends
- The company's return on assets
Correct answer: The ratio of debt to equity (or total capital)
Gearing measures the proportion of debt in a company's capital structure relative to equity or total capital. Higher gearing means more financial risk due to fixed interest obligations.
Question 4: Which source of finance is typically the cheapest for a company?
- Ordinary share capital
- Preference shares
- Debt (secured loan) (Correct answer)
- Convertible bonds
Correct answer: Debt (secured loan)
Secured debt is typically the cheapest source of finance because lenders have security over assets, reducing their risk; interest is also tax-deductible, further lowering the effective cost.
Question 5: A company's cash conversion cycle is the average time between:
- Receiving an order and issuing an invoice
- Paying for inventory and receiving cash from customers (Correct answer)
- Borrowing funds and repaying them
- Earning revenue and reporting it
Correct answer: Paying for inventory and receiving cash from customers
The cash conversion cycle = inventory days + receivables days − payables days. It measures how long cash is tied up in the operating cycle before being recovered from customers.
Question 6: Under the capital asset pricing model (CAPM), beta measures:
- The total risk of an investment
- The systematic (market) risk of an investment relative to the market (Correct answer)
- The credit risk of a bond
- The volatility of dividend payments
Correct answer: The systematic (market) risk of an investment relative to the market
Beta measures systematic risk — the sensitivity of a security's returns to movements in the overall market. Unsystematic risk can be diversified away; only systematic risk is rewarded in CAPM.
ACA Business Finance 2
Net present value (NPV) is considered superior to the payback period method because: