ACA Business Finance 4 — Questions and Answers
Question 1: Which valuation method is most appropriate for valuing a going concern with stable, predictable cash flows?
- Net asset value method
- Discounted cash flow (DCF) method (Correct answer)
- Price/earnings ratio method
- Replacement cost method
Correct answer: Discounted cash flow (DCF) method
DCF valuation is most appropriate for going concerns as it explicitly considers the present value of future cash flows, capturing the timing and risk of cash generation over the entity's life.
Question 2: Interest rate risk can be hedged using:
- Equity swaps
- Interest rate swaps (Correct answer)
- Credit default swaps
- Forward rate agreements only
Correct answer: Interest rate swaps
Interest rate swaps allow a company to exchange floating rate interest payments for fixed rate payments (or vice versa), effectively hedging the risk of interest rate movements.
Question 3: A convertible bond is attractive to investors because:
- It pays a higher coupon than equivalent straight debt
- It gives the option to convert to equity, participating in upside (Correct answer)
- It is always secured on company assets
- It is exempt from UK income tax
Correct answer: It gives the option to convert to equity, participating in upside
Convertible bonds offer downside protection (coupon payments) with upside potential (conversion to equity if the share price rises above the conversion price), making them attractive to investors.
Question 4: Which of the following would increase a company's operating leverage?
- Increasing variable costs relative to fixed costs
- Replacing fixed costs with variable costs
- Increasing the proportion of fixed costs in the cost structure (Correct answer)
- Reducing the scale of operations
Correct answer: Increasing the proportion of fixed costs in the cost structure
Operating leverage increases when fixed costs form a higher proportion of total costs. Higher fixed costs mean that once they are covered, incremental revenue flows strongly to profit — but losses are amplified in downturns.
Question 5: Which of the following is consistent with a company having a high dividend payout ratio?
- High growth opportunities requiring reinvestment
- Mature, stable business with limited reinvestment needs (Correct answer)
- Need to conserve cash for capital expenditure
- High financial gearing requiring debt repayment
Correct answer: Mature, stable business with limited reinvestment needs
Mature businesses with stable cash flows and few high-return investment opportunities tend to return surplus cash to shareholders through high dividend payouts.
Question 6: In the context of leasing, the main financial advantage of an operating lease over a finance lease for the lessee is:
- Lower total cost over the asset's life
- Off-balance-sheet financing under historical accounting rules (Correct answer)
- Higher tax deductions
- Ownership of the asset at the end of the lease
Correct answer: Off-balance-sheet financing under historical accounting rules
Historically, operating leases kept assets and liabilities off the balance sheet (prior to IFRS 16), improving reported gearing ratios. Under IFRS 16, this distinction has largely been eliminated for lessees.
ACA Business Finance 4
Which valuation method is most appropriate for valuing a going concern with stable, predictable cash flows?