FCCA Strategic Financial Management 2 — Questions and Answers
Question 1: When evaluating a foreign direct investment, which method is generally preferred for handling foreign currency cash flows?
- Convert all cash flows at the spot rate on the decision date
- Discount foreign currency cash flows at the foreign cost of capital, then convert at the current spot rate (Correct answer)
- Discount foreign currency cash flows at the domestic WACC
- Ignore exchange rate risk and use domestic cash flows only
Correct answer: Discount foreign currency cash flows at the foreign cost of capital, then convert at the current spot rate
The recommended approach is to discount the foreign currency cash flows using the foreign discount rate and then convert the resulting NPV to the domestic currency at the spot rate.
Question 2: Which of the following is a systematic (non-diversifiable) risk?
- A key employee leaving the firm
- A product recall affecting a single company
- A rise in interest rates across the economy (Correct answer)
- A fire destroying a company's warehouse
Correct answer: A rise in interest rates across the economy
Systematic risk affects the entire market or economy (e.g., interest rate changes) and cannot be eliminated through portfolio diversification.
Question 3: In a leveraged buyout (LBO), how is the acquisition primarily financed?
- Entirely with equity from the acquiring firm's retained earnings
- Predominantly with debt secured against the target company's assets and cash flows (Correct answer)
- Entirely with newly issued common shares
- Through government grants and subsidies
Correct answer: Predominantly with debt secured against the target company's assets and cash flows
An LBO uses large amounts of borrowed money, typically secured by the target's assets and future cash flows, to finance the acquisition.
Question 4: What is the primary purpose of a currency swap in strategic financial management?
- To speculate on future exchange rate movements for profit
- To exchange principal and interest payments in one currency for those in another to manage long-term currency exposure (Correct answer)
- To set a fixed exchange rate for a single upcoming transaction
- To eliminate all financial risk from a firm's operations
Correct answer: To exchange principal and interest payments in one currency for those in another to manage long-term currency exposure
A currency swap allows two parties to exchange streams of cash flows in different currencies, effectively hedging long-term foreign currency obligations.
Question 5: The Adjusted Present Value (APV) method separates a project's value into which two components?
- Operating cash flows and terminal value
- Base-case NPV (all-equity financed) and the present value of financing side effects (Correct answer)
- Book value of assets and market value of liabilities
- Free cash flow to equity and free cash flow to the firm
Correct answer: Base-case NPV (all-equity financed) and the present value of financing side effects
APV first calculates the NPV assuming all-equity financing, then adds the present value of financing benefits (such as the tax shield on debt) separately.
Question 6: Which hedging instrument gives the holder the right, but not the obligation, to buy or sell a currency at a pre-agreed rate?
- Forward contract
- Currency future
- Currency option (Correct answer)
- Interest rate swap
Correct answer: Currency option
A currency option grants the right (without obligation) to transact at the strike rate, providing downside protection while allowing upside participation.
Question 7: Under real options analysis, what does an 'option to abandon' a project represent?
- The right to delay starting the project until market conditions improve
- The right to sell the project's assets and cease operations if performance is poor (Correct answer)
- The right to expand production capacity if demand increases
- The right to switch between different production inputs
Correct answer: The right to sell the project's assets and cease operations if performance is poor
The option to abandon allows management to exit a project and recover residual value if continued operations would destroy value, analogous to a put option.
FCCA Strategic Financial Management 2
When evaluating a foreign direct investment, which method is generally preferred for handling foreign currency cash flows?