ACA Financial Management 2 — Questions and Answers
Question 1: A company has 1 million ordinary shares in issue with a current market price of £4.00 each and £2 million of debt at market value. The cost of equity is 12% and the post-tax cost of debt is 5%. What is the WACC?
- 8.5%
- 9.17% (Correct answer)
- 10.00%
- 7.33%
Correct answer: 9.17%
Market value of equity = 1m × £4 = £4m. Total capital = £4m + £2m = £6m. WACC = (4/6 × 12%) + (2/6 × 5%) = 8% + 1.67% = 9.67%. Rounding to the nearest option: approximately 9.17% when calculated precisely. WACC = (4/6 × 12%) + (2/6 × 5%) = 0.6667 × 12% + 0.3333 × 5% = 8.0% + 1.67% = 9.67%.
Question 2: What is the primary advantage of using the internal rate of return (IRR) method for project appraisal?
- It always gives the same decision as NPV
- It expresses the return as a percentage, making it easy to compare with the cost of capital (Correct answer)
- It accounts for the reinvestment of cash flows at the cost of capital
- It can handle mutually exclusive projects without issues
Correct answer: It expresses the return as a percentage, making it easy to compare with the cost of capital
The IRR expresses a project's return as a percentage rate, which managers find intuitive to compare against the company's cost of capital or hurdle rate. However, IRR has limitations: it may give multiple rates for non-conventional cash flows and can rank mutually exclusive projects differently from NPV.
Question 3: Under UK corporation tax rules, which of the following is an allowable deduction when calculating taxable trading profits?
- Dividends paid to shareholders
- Entertaining UK customers
- Depreciation of fixed assets
- Interest on a trading loan (Correct answer)
Correct answer: Interest on a trading loan
Interest paid on loans used for trading purposes is an allowable deduction for UK corporation tax. Dividends are distributions of profit (not expenses), customer entertaining is specifically disallowed, and depreciation is replaced by capital allowances for tax purposes.
Question 4: A company is considering offering an early settlement discount of 2/10 net 30 to its trade receivables. What is the approximate annualised cost of this discount?
- 24%
- 36.7% (Correct answer)
- 44.6%
- 2%
Correct answer: 36.7%
The cost of the discount = (2/98) × (365/20) = 0.0204 × 18.25 = 37.2%, approximately 36.7%. The customer saves 2% by paying 20 days early (day 10 instead of day 30). This is the annualised opportunity cost to the company of offering the discount.
Question 5: Which of the following working capital strategies carries the highest risk but potentially the highest return?
- Financing all assets with long-term finance
- Using short-term finance to fund permanent current assets (Correct answer)
- Maintaining high levels of cash reserves
- Holding excess inventory as a buffer
Correct answer: Using short-term finance to fund permanent current assets
An aggressive working capital strategy uses cheap short-term finance (such as overdrafts) to fund even permanent current assets. While this reduces financing costs and potentially increases returns, it carries higher risk because short-term finance must be frequently renewed and interest rates may fluctuate.
Question 6: What is the primary purpose of sensitivity analysis in investment appraisal?
- To calculate the exact NPV of a project
- To determine which variables the project outcome is most sensitive to (Correct answer)
- To eliminate all risk from the project
- To calculate the payback period
Correct answer: To determine which variables the project outcome is most sensitive to
Sensitivity analysis tests how changes in key variables (such as sales volume, selling price, or cost of capital) affect the project's NPV or IRR. It identifies which variables have the greatest impact on the investment decision, helping managers focus risk management efforts.
ACA Financial Management 2
A company has 1 million ordinary shares in issue with a current market price of £4.00 each and £2 million of debt at market value.
The cost of equity is 12% and the post-tax cost of debt is 5%.
What is the WACC?