ACCA AS Financial Management (FM) 2

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?

Accepted Answer

£6.00

Answer

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?

Accepted Answer

£406,504

Answer

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?

Accepted Answer

£5.20

Answer

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?

Accepted Answer

Borrowing the foreign currency now, converting to domestic currency at spot, and investing domestically

Answer

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?

Accepted Answer

The after-tax cost of borrowing

Answer

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.

ACCA Applied Skills Practice Test

ACCA Applied Skills Practice Test

ACCA AS Financial Management (FM) 2