Advanced Financial Management (AFM) Flashcards

A UK company is evaluating a project with the following data: equity beta 1.2, risk-free rate 3%, equity risk premium 6%, cost of debt (pre-tax) 5%, tax rate 25%, gearing (debt to total capital) 30%. What is the WACC?

Answer: 8.27%

Cost of equity (CAPM) = 3% + 1.2 × 6% = 10.2%. After-tax cost of debt = 5% × (1 - 0.25) = 3.75%. Equity weighting = 70%, debt weighting = 30%. WACC = (0.70 × 10.2%) + (0.30 × 3.75%) = 7.14% + 1.125% = 8.265%, rounded to 8.27%. The WACC represents the minimum return the company must earn on its investments to satisfy both equity and debt holders.

A company is considering using a currency swap to manage its foreign exchange exposure on a USD-denominated loan. Which of the following BEST describes the primary advantage of a currency swap over a forward contract?

Answer: Currency swaps can hedge both the principal and periodic interest payments over the loan term

The primary advantage of a currency swap over a forward contract for hedging a foreign currency loan is that the swap can hedge both the periodic interest payments (through regular exchanges of interest) and the principal repayment (through the re-exchange of principal at maturity). A forward contract only hedges a single future cash flow, making it impractical for a series of payments.

In the context of business valuations, what is the main limitation of using the price/earnings (P/E) ratio method to value an unlisted company?

Answer: It is difficult to find a truly comparable listed company, and a discount for lack of marketability must be applied

The P/E ratio method involves applying the P/E ratio of a comparable listed company to the target's earnings. The main limitations are: (1) finding a genuinely comparable company (same risk, growth, sector), and (2) unlisted shares lack marketability, so a discount (typically 20-30%) must be applied. Without these adjustments, the valuation will likely overstate the unlisted company's value.

A company can issue a convertible bond or a bond with warrants. Which of the following statements about warrants is CORRECT?

Answer: Warrants are detachable and can be traded separately from the host bond

Warrants are detachable from the host bond, meaning they can be traded separately in the secondary market. This is a key distinction from convertible bonds, where the conversion right is embedded and cannot be separated. When warrants are exercised, the bondholder pays the exercise price in cash AND retains the bond, whereas convertible bondholders surrender the bond for shares.

An investor holds a portfolio of UK equities and is concerned about a market downturn. To hedge using FTSE 100 index futures, the investor should:

Answer: Sell FTSE 100 futures to offset losses if the market falls

To hedge a long equity portfolio against a market decline, the investor should sell (go short) FTSE 100 index futures. If the market falls, the loss on the portfolio is offset by gains on the short futures position. The number of contracts needed depends on the portfolio's beta relative to the FTSE 100. This is a systematic risk hedge.

Under the adjusted present value (APV) method, the base case NPV is calculated by discounting project cash flows at:

Answer: The ungeared cost of equity (Ke ungeared)

The APV method separates the investment decision from the financing decision. The base case NPV uses the ungeared cost of equity (the cost of equity assuming the project is entirely equity-financed) to discount operating cash flows. The tax shield from debt and other financing side effects are then calculated separately and added to the base case NPV.