ACCA Financial Management and Investment 5 — Questions and Answers
Question 1: A company evaluates a lease-versus-buy decision. Which discount rate should be used to discount the after-tax lease payments?
- The firm's WACC
- The pre-tax cost of debt
- The after-tax cost of borrowing (Correct answer)
- The equity beta-adjusted rate
Correct answer: The after-tax cost of borrowing
Lease payments are similar to debt obligations, so the after-tax cost of borrowing is the appropriate rate to discount them in a lease vs. buy analysis.
Question 2: Transaction exposure in foreign exchange management refers to:
- The impact of exchange rate changes on reported financial statements
- The risk that future exchange rates will affect long-term competitive position
- The risk arising from existing contractual obligations in foreign currency (Correct answer)
- The risk of translating overseas subsidiary accounts
Correct answer: The risk arising from existing contractual obligations in foreign currency
Transaction exposure arises from already-committed foreign currency transactions such as receivables, payables, and loan repayments.
Question 3: Which capital budgeting method is most appropriate when comparing projects with unequal useful lives?
- Net Present Value (NPV)
- Internal Rate of Return (IRR)
- Equivalent Annual Annuity (EAA) or Equivalent Annual Cost (EAC) (Correct answer)
- Accounting Rate of Return (ARR)
Correct answer: Equivalent Annual Annuity (EAA) or Equivalent Annual Cost (EAC)
EAA converts each project's NPV into an equivalent annual figure, enabling fair comparison of projects with different time horizons.
Question 4: A company's WACC is 10%. A new project has a beta of 1.5, the risk-free rate is 4%, and the market risk premium is 6%. Should the project be evaluated at the WACC?
- Yes, WACC is always the correct discount rate
- No, use the project's own risk-adjusted rate of 13% (Correct answer)
- No, use the project's own risk-adjusted rate of 10%
- Yes, but only if the project is financed with equity
Correct answer: No, use the project's own risk-adjusted rate of 13%
The project-specific rate = Rf + β(Rm - Rf) = 4% + 1.5 × 6% = 13%; using WACC would understate the required return for this higher-risk project.
Question 5: Which of the following best explains why dividends may be irrelevant in a perfect capital market (Modigliani-Miller dividend irrelevance theory)?
- Investors always prefer capital gains over dividends
- Investors can create homemade dividends by selling shares (Correct answer)
- Tax advantages always favor dividend income
- Dividends signal management's confidence in future earnings
Correct answer: Investors can create homemade dividends by selling shares
In a perfect market, investors can replicate any desired income stream by selling shares ('homemade dividends'), making the firm's dividend policy irrelevant to its value.
Question 6: A rights issue is made at a price below the current market price. What is the typical effect on the theoretical ex-rights price?
- It equals the pre-rights market price
- It falls between the issue price and the pre-rights market price (Correct answer)
- It equals the new issue price
- It exceeds the pre-rights market price
Correct answer: It falls between the issue price and the pre-rights market price
The theoretical ex-rights price is a weighted average of the pre-rights price and the new issue price, so it falls between the two.
Question 7: Under interest rate parity (IRP), what condition ensures no arbitrage profit exists between two countries?
- Forward premium/discount equals the inflation differential
- Forward premium/discount equals the interest rate differential (Correct answer)
- Exchange rates adjust to equalize purchasing power
- Real interest rates are equal across all markets
Correct answer: Forward premium/discount equals the interest rate differential
Covered Interest Rate Parity states that the forward exchange rate premium or discount must equal the difference in interest rates between the two currencies.
ACCA Financial Management and Investment 5
A company evaluates a lease-versus-buy decision.
Which discount rate should be used to discount the after-tax lease payments?