ACCA Financial Management and Investment 3 — Questions and Answers
Question 1: A company has EBIT of $800,000, interest expense of $100,000, and a tax rate of 30%. What is the interest coverage ratio?
- 5.6x
- 7.0x
- 8.0x (Correct answer)
- 6.2x
Correct answer: 8.0x
Interest coverage = EBIT / Interest = $800,000 / $100,000 = 8.0 times.
Question 2: Which of the following is the main advantage of issuing convertible bonds from the issuer's perspective?
- Higher coupon payments than straight bonds
- Avoidance of dividend payments in perpetuity
- Lower coupon rates due to the embedded conversion option (Correct answer)
- Immediate equity dilution without market impact
Correct answer: Lower coupon rates due to the embedded conversion option
Convertible bonds carry a lower coupon because investors value the option to convert into equity, reducing the issuer's interest cost.
Question 3: In Modigliani-Miller theory with taxes, what happens to firm value as financial leverage increases?
- Firm value decreases due to financial distress costs
- Firm value is unchanged regardless of leverage
- Firm value increases due to the tax shield on debt interest (Correct answer)
- Firm value first increases then decreases at an optimal point
Correct answer: Firm value increases due to the tax shield on debt interest
MM with taxes shows firm value rises with debt because interest payments are tax-deductible, creating a tax shield that adds value.
Question 4: A portfolio contains two assets. Asset A has a standard deviation of 10% and Asset B has 20%. The correlation between them is 0. What is the portfolio standard deviation if equal weights are used?
- 15%
- 11.18% (Correct answer)
- 10%
- 12.5%
Correct answer: 11.18%
Portfolio variance = (0.5)²(0.1)² + (0.5)²(0.2)² = 0.0025 + 0.01 = 0.0125; SD = √0.0125 ≈ 11.18%.
Question 5: Which ratio measures how efficiently a company uses its assets to generate sales?
- Return on equity
- Asset turnover ratio (Correct answer)
- Current ratio
- Gross profit margin
Correct answer: Asset turnover ratio
Asset turnover = Revenue / Total Assets, measuring how much revenue is generated per dollar of assets.
Question 6: A call option on a stock has a strike price of $40 and the stock currently trades at $45. What is the intrinsic value of this option?
- $0
- $5 (Correct answer)
- $40
- $45
Correct answer: $5
Intrinsic value of a call = max(S - K, 0) = max($45 - $40, 0) = $5.
Question 7: Under the Pecking Order Theory, which source of financing do firms prefer first?
- Equity issuance
- Convertible debt
- Retained earnings (internal finance) (Correct answer)
- Bank loans
Correct answer: Retained earnings (internal finance)
Pecking Order Theory states firms prefer internal financing first to avoid the adverse selection signaling problems of external finance.
ACCA Financial Management and Investment 3
A company has EBIT of $800,000, interest expense of $100,000, and a tax rate of 30%.
What is the interest coverage ratio?