ACCA AS Financial Management (FM) 2 — Questions and Answers
Question 1: A company has earnings per share (EPS) of £0.50 and the industry average P/E ratio is 12. Using the P/E ratio method, what is the estimated value per share?
- £0.50
- £6.00 (Correct answer)
- £12.00
- £24.00
Correct answer: £6.00
Value per share = EPS × P/E ratio = £0.50 × 12 = £6.00. The P/E ratio method values the company by applying an appropriate earnings multiple to the company's earnings. Using the industry average P/E assumes the company should be valued similarly to its peers.
Question 2: A UK company expects to receive $500,000 in three months. The current spot rate is $1.25/£. To hedge using a forward contract, the three-month forward rate is $1.23/£. What sterling amount will the company receive?
- £400,000
- £406,504 (Correct answer)
- £615,000
- £625,000
Correct answer: £406,504
Using the forward contract, the company locks in the forward rate. Sterling receipt = $500,000 / $1.23 = £406,504. The forward rate of $1.23/£ is more favourable than the spot rate of $1.25/£ (fewer dollars per pound means the pound is weaker, so more pounds are received for the same dollar amount).
Question 3: According to the Gordon Growth Model (dividend valuation model), what is the share price if the dividend just paid is £0.30, the cost of equity is 10%, and dividends are expected to grow at 4% per year?
- £3.00
- £5.00
- £5.20 (Correct answer)
- £7.50
Correct answer: £5.20
Using the Gordon Growth Model: P₀ = D₀(1+g) / (Ke − g) = £0.30 × 1.04 / (0.10 − 0.04) = £0.312 / 0.06 = £5.20. The formula uses the next expected dividend (D₁), so the dividend just paid must be grown by one period. The denominator is the cost of equity minus the growth rate.
Question 4: Which of the following is a money market hedge for a future foreign currency receipt?
- Buying a call option on the foreign currency
- Borrowing the foreign currency now, converting to domestic currency at spot, and investing domestically (Correct answer)
- Entering into a forward contract to sell the foreign currency
- Buying the foreign currency forward
Correct answer: Borrowing the foreign currency now, converting to domestic currency at spot, and investing domestically
A money market hedge for a foreign currency receipt involves: (1) borrowing the present value of the expected foreign currency receipt now, (2) converting the borrowed amount to domestic currency at today's spot rate, and (3) investing the domestic currency. When the receipt arrives, it repays the foreign currency loan. This effectively locks in today's spot rate.
Question 5: A company can either lease or buy a machine costing £50,000. The lease requires annual payments of £12,000 for 5 years. The company's borrowing rate is 8% and the tax rate is 25%. In a lease-versus-buy decision, which discount rate should typically be used?
- The company's WACC
- The company's cost of equity
- The after-tax cost of borrowing (Correct answer)
- The risk-free rate
Correct answer: The after-tax cost of borrowing
In a lease-versus-buy decision, the appropriate discount rate is the after-tax cost of borrowing. This is because the lease replaces debt financing, so the cash flows should be compared using the cost of the alternative financing source. The after-tax borrowing rate here would be 8% × (1 − 0.25) = 6%. WACC is not appropriate as this is a financing decision, not an investment decision.
Question 6: What is the primary objective of working capital management?
- To maximise the level of current assets held
- To minimise the level of current liabilities
- To ensure the company has sufficient liquidity to meet short-term obligations while minimising the cost of holding current assets (Correct answer)
- To eliminate all trade payables
Correct answer: To ensure the company has sufficient liquidity to meet short-term obligations while minimising the cost of holding current assets
Working capital management aims to balance liquidity (having enough current assets to meet obligations) with profitability (minimising the cost of holding excessive working capital). Holding too many current assets is costly (opportunity cost), while holding too few risks insolvency. The goal is an optimal balance, not maximisation or minimisation of any single component.
ACCA AS Financial Management (FM) 2
A company has earnings per share (EPS) of £0.50 and the industry average P/E ratio is 12.
Using the P/E ratio method, what is the estimated value per share?