F2: Financing projects

Answer: A. Debt carries a contractual obligation — interest must be paid and principal repaid regardless of profit, and debt ranks ahead of equity on liquidation. Equity holders are residual claimants: they receive distributions (dividends) only after all obligations are met, and there is no guaranteed return. Equity does not receive fixed interest; that is a characteristic of debt. While debt is often cheaper than equity on a pre-tax basis due to the tax shield, this does not hold in all situations. Debt and equity do not rank equally on liquidation — debt has priority.

Answer: B. Capital markets are organised markets — including stock exchanges and bond markets — whose primary role is to connect organisations that need long-term finance with investors willing to supply it, enabling the raising of equity through share issuance and long-term debt through bond markets. Short-term working capital lending is the province of money markets and commercial banks. Interest rate setting is a central bank function. Accounting standard regulation is the role of bodies such as the IASB and national regulators, not capital markets.

Answer: C. DVM (no growth): Ke = D ÷ P0 = 30p ÷ 400p = 0.075 = 7.5%. This formula assumes dividends are constant perpetuity with no growth. 13.3% inverts the formula (400 ÷ 30 = 13.3), which is a price-to-dividend multiple, not a cost of equity. 5.0% and 12.0% do not follow from the figures; with no growth there is nothing to add to the dividend yield.

Answer: D. DVM with growth: Ke = D1 ÷ P0 + g, where D1 = D0 × (1 + g) = 50p × 1.04 = 52p. Ke = 52p ÷ 800p + 0.04 = 0.065 + 0.04 = 0.105 = 10.5%. A common error is to use D0 in the numerator rather than the next expected dividend D1 (50 ÷ 800 + 4% = 10.25%, shown as 10.3%). Another is to forget to add the growth rate: 52 ÷ 800 = 6.5%, which gives only the dividend yield. 14.5% does not follow from the figures.

Answer: A. Post-tax cost of irredeemable debt = I × (1 − t) ÷ market price = £8 × (1 − 0.25) ÷ £95 = £6 ÷ £95 = 6.3%. The pre-tax cost is £8 ÷ £95 = 8.4%, which ignores the tax deductibility of interest. Using par value as denominator instead of market price gives £6 ÷ £100 = 6.0%, a common error. The coupon rate of 8% is the nominal rate on par, not the actual cost to the company at market price.

Answer: B. WACC = (weight of equity × Ke) + (weight of debt × Kd) = (0.60 × 12%) + (0.40 × 5%) = 7.2% + 2.0% = 9.2%. A common error is to use book values rather than market values for weights (if given, market values should be used). Another is to use the pre-tax cost of debt. Equally weighting both at 50% each gives (0.5 × 12%) + (0.5 × 5%) = 8.5%, ignoring the 60/40 split. 8.0% is roughly what swapping the weights gives (0.40 × 12% + 0.60 × 5% = 7.8%), and 10.0% does not follow from the figures.

Answer: C. For redeemable debt, the investor receives not just periodic interest payments but also a lump sum at redemption — which may differ from what they paid for the bond. YTM captures both the interest income stream and the capital gain (if bought at a discount) or loss (if bought at a premium), giving the total return demanded by the market on that debt. The coupon rate only reflects the interest relative to par value and ignores these capital flows. YTM and the coupon rate are equal only when the bond trades at par; they diverge at premium or discount prices. Coupon rates are publicly disclosed.

Answer: D. WACC is used to discount future cash flows at the rate the company needs to earn to satisfy investors at today's market prices. Market values reflect what investors currently require for their capital — the opportunity cost of finance today — whereas book values reflect what was raised historically and may be very different from current reality. Market values are more appropriate for forward-looking investment decisions. The argument that book values are easier to obtain does not make them equally accurate; they can distort WACC significantly. Accounting standards govern the book values reported in financial statements, not the inputs for WACC calculations.

Answer: A. A rights issue offers new shares to existing shareholders in proportion to their existing holding — for example, a 1-for-4 rights issue allows shareholders to buy one new share for every four they already hold — typically at a price below the current market price to provide an incentive to subscribe. Existing shareholders who take up their rights maintain their proportionate ownership; those who do not face dilution. The price is set at a discount, not a premium, to incentivise participation — and the issue is reserved for existing shareholders, not new investors.

Answer: B. Investors value the conversion option — the right to exchange bonds for shares if the share price rises sufficiently — which means they accept a lower interest rate (coupon) in compensation for this potential upside. This lowers the issuing company's interest cost relative to non-convertible debt. Conversion is typically at the investor's option and may never occur (if the share price does not reach the conversion threshold). Under IAS 32, convertible debt is split into its liability and equity components from issuance — the liability component is not reclassified as equity until conversion. Before conversion, the debt component increases the debt-to-equity ratio, not reduces it.

Answer: D. WACC = (weight × cost) for each component = (0.50 × 14%) + (0.10 × 8%) + (0.40 × 5%) = 7.0% + 0.8% + 2.0% = 9.8%. Note that preference share dividends are not tax-deductible (unlike debt interest), so the 8% cost is already the post-tax cost. 9.0% leaves out the preference shares (7.0% + 2.0%), and 8.5% does not follow from the costs and weights. 11.2% overstates the result, for example by using a pre-tax cost of debt or the wrong weights.

Answer: A. CAPM: Ke = Rf + β(Rm − Rf) = 4% + 1.2 × (10% − 4%) = 4% + 1.2 × 6% = 4% + 7.2% = 11.2%. The equity risk premium (ERP) is Rm − Rf = 6%, not Rm itself. Using the full market return (4% + 1.2 × 10% = 16%) incorrectly applies beta to Rm rather than the ERP. Using beta × ERP alone (1.2 × 6% = 7.2%) omits the risk-free rate. The 8% figure might arise from adding beta to the risk-free rate (4% + 1.2 × 4%). The ERP is the premium above the risk-free rate, not the market return itself.

Answer: B. TERP = (existing shares × current price + new shares × rights price) ÷ total shares after issue = (4 × 300p + 1 × 250p) ÷ 5 = (1,200p + 250p) ÷ 5 = 1,450p ÷ 5 = 290p. The TERP lies between the current price (300p) and the rights price (250p), weighted by the proportion of old and new shares. Taking the simple average of 300p and 250p (275p) ignores the 4-for-1 weighting. The current price (300p) and rights price (250p) are individual components, not the combined TERP.

Answer: C. Value per share = EPS × P/E = 40p × 18 = 720p. This applies the earnings multiple of the listed comparable to the private company's earnings to estimate an equivalent market value. In practice, a discount is often applied to the P/E multiple for private companies to reflect lower marketability and liquidity of unlisted shares. The 40p figure is just the EPS. The 450p would arise from using an incorrectly lower P/E, and the 900p from an inflated multiplier.

Answer: D. Net proceeds per share = 500p × (1 − 5%) = 475p. Cost of new equity = D1 ÷ P0_net + g = 25p ÷ 475p + 5% = 5.26% + 5% = 10.26%. Flotation costs reduce the net proceeds available to the company, increasing the cost of new equity above that of retained earnings. Using the full issue price (500p) gives 25 ÷ 500 + 5% = 10.0%, which understates the true cost. The 10.5% figure would arise from a slightly different flotation adjustment. The 5.26% is just the dividend yield component without adding the growth rate.

Answer: A. The WACC represents the blended required return across all investors (equity and debt holders), weighted by market value. Using it as a discount rate implies that a project earning at least the WACC earns enough to satisfy all investors. This is appropriate when the project carries the same systematic business risk as the company and is financed in the same proportions as the overall capital structure. For projects with significantly different risk profiles or financing structures, adjusted discount rates (such as adjusted present value or project-specific betas) are more appropriate. WACC is not fixed by accounting standards.

Answer: B. Cost of preference shares = annual dividend ÷ market price = (6% × £100) ÷ £80 = £6 ÷ £80 = 7.5%. Unlike debt interest, preference dividends are not deductible for corporation tax — they are paid out of after-tax profits, making them more expensive than debt on an after-tax basis. The 6% coupon rate is the dividend as a percentage of par, not the true cost relative to market price. Preference dividends do not receive any tax deduction, so 4.5% (after a 25% tax reduction) is incorrect.

Answer: B. Venture capital provides equity (or equity-like) funding to high-growth businesses — often start-ups or early-stage companies — in exchange for a substantial ownership stake, with the expectation of a profitable exit (via IPO, trade sale or management buyout) after typically 3–7 years. It is not a government grant; it is private risk capital. Venture capitalists take equity, not fixed-interest loans (though some use convertible instruments). The exit strategy is a defining feature — venture capital funds do not retain holdings indefinitely.

Answer: C. Market value of irredeemable bond = annual interest ÷ required return = £8 ÷ 0.10 = £80. This treats the bond as a perpetuity, since there is no redemption payment. If the required return rises above the coupon rate, the bond trades below par — here the coupon yield at par would be 8%, but investors require 10%, so the price falls to £80. The £100 figure is par value, which only prevails if the required return equals the coupon rate (8% ≠ 10%). The £108 and £88 figures arise from incorrect formulae.

Answer: D. Under Modigliani-Miller with corporate taxes (M&M with tax), increasing debt creates a tax shield — the tax deductibility of interest payments reduces the effective cost of debt financing. This causes WACC to fall as gearing rises, and company value to increase. M&M therefore implies a 100% debt capital structure is theoretically optimal (though this is moderated by financial distress costs in real-world practice). Without taxes, M&M concluded capital structure is irrelevant. The tax shield is the key mechanism that drives the falling WACC with gearing in the M&M with tax model.

Answer: A. When a company already has high gearing, taking on additional debt raises the risk of breaching existing loan covenants and increases the probability of financial distress — at this point, the cost of debt may be very high and equity may be preferable despite its higher normal cost. Share issues are not always cheaper than debt — debt is typically cheaper in absolute terms due to the tax shield and lower required return. Rights issues take considerable time to arrange (documentation, regulator approval, subscription period), so speed is not an advantage over debt. Debt maturity varies — many loans are medium or long-term.

Answer: B. The compound annual growth rate = (terminal value ÷ initial value)^(1/n) − 1 = (26.5 ÷ 20)^(1/5) − 1 = 1.325^0.20 − 1 ≈ 1.0577 − 1 = 5.77% ≈ 5.8%. Dividing the total growth by years and by the base (6.5 ÷ 20 ÷ 5 = 6.5%) approximates simple annual growth, ignoring compounding. Dividing the pence change by 5 years (1.3p) gives an absolute amount, not a rate. Subtracting 1 from the total ratio (26.5 ÷ 20 = 1.325) gives the total 5-year growth, not the annual rate.