ACCA AS Financial Management 2 — Questions and Answers
Question 1: The Modigliani-Miller (MM) proposition (without tax) states that:
- A company should use as much debt as possible
- The value of a geared firm equals the value of an equivalent ungeared firm; capital structure is irrelevant (Correct answer)
- Dividends are irrelevant to share value
- A company's WACC falls as it increases debt
Correct answer: The value of a geared firm equals the value of an equivalent ungeared firm; capital structure is irrelevant
MM (1958, no tax) argued that in perfect capital markets, capital structure does not affect firm value; the gain in cheap debt is exactly offset by increased equity risk.
Question 2: Which of the following is a characteristic of a 'rights issue'?
- New shares are sold to the general public for the first time
- Existing shareholders are offered new shares in proportion to their current holdings at a discount (Correct answer)
- Shares are issued as consideration in a takeover
- Bonus shares are issued to existing shareholders at no cost
Correct answer: Existing shareholders are offered new shares in proportion to their current holdings at a discount
A rights issue offers new shares to existing shareholders pro-rata to their holdings, usually at a discount to the market price, to raise additional equity capital.
Question 3: Which of the following is the formula for the dividend growth model (Gordon Growth Model) for share valuation?
- P0 = D0 ÷ Ke
- P0 = D1 ÷ (Ke − g) (Correct answer)
- P0 = D0 × (1 + g)
- P0 = EPS ÷ Ke
Correct answer: P0 = D1 ÷ (Ke − g)
Gordon Growth Model: P0 = D1 ÷ (Ke − g), where D1 is next year's dividend, Ke is the cost of equity and g is the constant annual dividend growth rate.
Question 4: Which of the following describes a 'factoring' arrangement?
- The company issues bonds to finance its operations
- The company sells its trade receivables to a factor (finance house) to improve cash flow (Correct answer)
- The company leases assets rather than buying them
- The company borrows against the security of its inventory
Correct answer: The company sells its trade receivables to a factor (finance house) to improve cash flow
Factoring involves selling receivables to a factor, which advances a percentage of the invoice value immediately, improving the company's cash flow and removing credit risk.
Question 5: An increase in the receivables collection period (debtor days) would:
- Reduce working capital requirements
- Increase working capital requirements (Correct answer)
- Have no effect on cash flow
- Improve the current ratio
Correct answer: Increase working capital requirements
If receivables take longer to collect, more cash is tied up in working capital. This increases the operating cycle and the company's financing need for working capital.
Question 6: The capital asset pricing model (CAPM) states that the required return on an equity investment is:
- Equal to the dividend yield plus expected capital gain
- The risk-free rate plus a premium for systematic (market) risk, measured by beta (Correct answer)
- The weighted average of the dividend yield and earnings yield
- The coupon rate on comparable corporate bonds
Correct answer: The risk-free rate plus a premium for systematic (market) risk, measured by beta
CAPM: Ke = Rf + β(Rm − Rf). The required return equals the risk-free rate plus beta times the equity risk premium, where beta measures systematic risk.
ACCA AS Financial Management 2
The Modigliani-Miller (MM) proposition (without tax) states that: