FM: Business finance

Answer: B. Ordinary shareholders are the owners of the company: they rank last in a winding up and their dividends are discretionary, so they bear the most risk, but in return they hold voting rights and are entitled to the residual profits after all prior claims. Option A describes preference shares, option C is wrong because ordinary shares are normally irredeemable, and option D is false — dividends are an appropriation of profit, not a tax-deductible expense like debt interest.

Answer: C. Debt is generally cheaper than equity for the same company because lenders bear less risk (ranking ahead of shareholders and often holding security) and because interest is tax-deductible, creating a 'tax shield'. Option A is the wrong way round (debt's required return is lower than equity's), option B is untrue (lenders do not normally have voting control), and option D is false — debt usually carries a repayment obligation and interest must be paid regardless of profits.

Answer: D. TERP = (value of the existing shares + proceeds of the new share) ÷ the total number of shares after the issue. For four shares at £5.00 plus one new share at £4.00: (4 × £5.00 + 1 × £4.00) ÷ 5 = £24.00 ÷ 5 = £4.80. The ex-rights price settles between the old market price and the issue price. Option A ignores the dilution, option B is the issue price, and option C is a simple average that ignores the 4:1 weighting of old to new shares.

Answer: A. The value of a right per new share = theoretical ex-rights price − issue price = £4.80 − £4.00 = £0.80. This is the value attaching to the right to subscribe for one new share at the discounted price; a shareholder who does not wish to take up the offer can sell the rights for approximately this amount, leaving their wealth unchanged in theory. Option B and option C use incorrect bases, and option D simply restates the ex-rights price.

Answer: B. A convertible bond is debt that the holder may, at a specified future date, choose to convert into a set number of ordinary shares rather than redeem for cash. The conversion option usually lets the company pay a lower coupon, and conversion (if it occurs) avoids the cash outflow of redemption. Option A misstates the redemption terms, option C describes a different instrument, and option D is wrong — bondholders do not vote unless and until they convert into shares.

Answer: C. Musharaka is a partnership in which the parties contribute capital, share profits in agreed proportions and share losses in proportion to capital, making it the closest equivalent to equity finance. Murabaha (option A) is a cost-plus sale resembling trade credit, ijara (option B) is akin to leasing, and sukuk are asset-backed certificates that behave more like bonds. FM requires knowledge of the nature of these products rather than calculations, and the examiner has noted candidates confusing the terms.

Answer: D. An overdraft is a flexible facility, usually repayable on demand and intended for short-term, fluctuating working-capital needs, with interest charged only on the amount drawn. A term loan provides a fixed sum for a set period with a scheduled repayment profile, suited to longer-term financing. Option A is not always true, option B reverses the two facilities, and option C wrongly treats them as identical long-term finance.

Answer: A. Venture capital is medium- to long-term equity or quasi-equity finance provided to higher-risk companies — often young, unlisted firms with high growth potential — typically in exchange for a substantial equity stake and some influence over the business, with the investor aiming to exit at a profit after several years. Option B describes a grant, option C a short-term facility and option D a risk-free instrument, none of which captures the nature of venture capital.

Answer: C. The dividend valuation model holds that the value of a share is the present value of its expected future dividends; rearranged, the cost of equity equals the dividend yield plus the expected dividend growth rate (Ke = D1/P0 + g). It therefore depends on expected future dividends, the current share price and the growth rate. Option A uses an irrelevant nominal value, option B uses accounting profit instead of dividends and price, and option D is irrelevant to the model.

Answer: A. Cost of equity Ke = D1 ÷ P0 + g, where D1 is next year's dividend = 20p × 1.05 = 21p. Ke = 21 ÷ 300 + 0.05 = 0.07 + 0.05 = 0.12 = 12.0%. Option C (7.0%) is the dividend yield alone, forgetting to add growth. Option B (11.7%) uses this year's dividend D0 (20p) instead of next year's D1. Option D (6.7%) is the yield on D0 only. The model adds the dividend yield and the growth rate to give the total return required by shareholders.

Answer: B. Under Gordon's growth model, g = retention ratio × return on reinvested funds = 0.40 × 0.15 = 0.06 = 6%. Growth is generated by reinvesting retained profits at the rate of return the company earns on them. Option A is the return on reinvestment alone, option C is the retention ratio alone, and option D simply adds the two figures. The retained proportion and the return earned on it together drive sustainable dividend growth.

Answer: C. CAPM holds that investors require a return only for systematic (market) risk, because unsystematic (company-specific) risk can be diversified away in a well-spread portfolio. The required return = risk-free rate + beta × equity risk premium, where beta measures the share's sensitivity to overall market movements. Option A wrongly includes diversifiable risk, option B uses accounting profit, and option D describes the dividend growth model rather than CAPM.

Answer: D. CAPM: Ke = Rf + β × (Rm − Rf) = 4% + 1.3 × (10% − 4%) = 4% + 1.3 × 6% = 4% + 7.8% = 11.8%. Option A multiplies beta by the whole market return (1.3 × 10%), option C adds the full market return to the premium, and option B is simply the market return. The term (Rm − Rf) is the equity risk premium, scaled by beta to reflect the share's systematic risk.

Answer: A. Unsystematic (company- or industry-specific) risk can be largely eliminated by holding a diversified portfolio, because specific good and bad events tend to offset one another. Systematic (market) risk affects all investments and cannot be diversified away, which is why CAPM rewards only systematic risk through beta. Option B reverses the two, and options C and D both misstate what diversification can achieve.

Answer: B. For irredeemable debt, after-tax cost = interest × (1 − tax rate) ÷ market value = £8 × (1 − 0.30) ÷ £80 = £5.60 ÷ £80 = 7.0%. Option C ignores tax (£8 ÷ £80 = 10%), option A uses the coupon rate against nominal value, and option D expresses the after-tax interest as a percentage of nominal value rather than market value. The market value, not the nominal value, must be used as the denominator.

Answer: C. The cost of redeemable debt is the internal rate of return (yield to maturity) that equates the current market value with the present value of the future after-tax interest payments and the redemption amount. It is found by interpolation between two trial discount rates, just like a project IRR. Options A and B ignore the time value of money and any redemption gain or loss, and option D wrongly applies a dividend concept to debt.

Answer: D. Cost of preference shares = annual preference dividend ÷ market value = 6p ÷ 75p = 8.0%. The 6% rate applies to the £1 nominal value to give a 6p dividend, but the yield is measured against the 75p market price. Preference dividends are not tax-deductible, so — unlike debt interest — there is no tax adjustment. Option A uses the nominal value as the denominator, and options B and C apply incorrect adjustments.

Answer: A. WACC = (proportion of equity × cost of equity) + (proportion of debt × after-tax cost of debt). Total value = £10m, so the equity weight is 0.6 and the debt weight is 0.4. WACC = (0.6 × 12%) + (0.4 × 7%) = 7.2% + 2.8% = 10.0%. Option D simply adds the two costs, and options B and C come from incorrect weightings such as book values or equal weights. Market values must be used for the weights.

Answer: B. Market values are used because they reflect what investors could earn elsewhere — the true opportunity cost of the funds — and therefore give a more realistic cost of capital. Equity market value often differs greatly from book value, so book-value weights can materially distort the WACC. Option A puts convenience above accuracy, option C is not generally true, and option D is wrong because the choice can change the WACC significantly. The examiner regularly penalises the use of book-value weightings.

Answer: C. The existing WACC is a valid discount rate only if the new project has broadly the same business risk as current activities and is financed so that the capital structure — and therefore financial risk — is left broadly unchanged. If either business or financial risk differs materially, a project-specific rate (for example one derived through a CAPM-based approach) is needed instead. Options A, B and D all describe situations where the existing WACC would not be appropriate.

Answer: D. An asset (ungeared) beta reflects the systematic business risk of a company's operations as though it had no debt. An equity (geared) beta reflects both that business risk and the extra financial risk created by gearing, so for a geared company the equity beta exceeds the asset beta. This is why, when appraising a project of a different risk class, a proxy company's asset beta is regeared to the appraising company's own capital structure. Options A, B and C all misstate the relationship.

Answer: A. Debt is cheaper because lenders take less risk than shareholders — they rank ahead on a winding up, often hold security, and receive contractual interest — so they require a lower return; in addition, interest is tax-deductible, lowering the effective cost further through the tax shield. Option B is wrong (debt holders receive interest, not dividends), option C is irrelevant to the cost comparison, and option D is untrue, as debt does not normally carry voting rights.

Answer: B. The choice of finance depends on matters such as the level of gearing and financial risk the company and its shareholders will accept, the availability of security for borrowing, the maturity of the finance relative to the asset being funded, the relative cost of each source, and the wish to retain control. Option B captures several of these considerations, whereas options A, C and D list factors that are irrelevant to the financing decision.

Answer: C. The traditional view holds that, as cheaper debt is first introduced, the WACC falls; but beyond a point the rising financial risk pushes up the cost of equity (and eventually the cost of debt), so the WACC reaches a minimum at an optimal gearing level and then rises. This implies an optimal capital structure exists. Options A and D misstate the pattern, and option B describes the Modigliani-Miller no-tax view rather than the traditional one.

Answer: D. In Modigliani and Miller's world without taxes, the WACC is constant whatever the level of gearing: as cheaper debt is added, the cost of equity rises by exactly enough to offset the benefit, so total company value is unaffected by capital structure. Option C describes the traditional view, while options A and B describe continuous movements the no-tax model does not predict. The conclusion changes once corporate tax is introduced.

Answer: A. Once corporate tax is introduced, debt interest is tax-deductible, so the tax shield adds value as gearing rises and the WACC falls. Taken to its logical conclusion, the basic model implies a company should be financed almost entirely by debt. In practice this is tempered by bankruptcy and agency costs, which the basic model ignores. Option B describes the no-tax case, and options C and D contradict the tax-shield benefit.

Answer: B. Interest cover = profit before interest and tax ÷ interest payable = £600,000 ÷ £150,000 = 4.0 times. This shows how many times operating profit covers the interest commitment; a higher figure means a greater safety margin and lower financial risk. Option C inverts the ratio, option D expresses that inverse as a percentage, and option A does not follow from the figures. Lenders watch interest cover closely as an indicator of default risk.

Answer: C. The funding gap describes SMEs' difficulty in raising finance: they are often viewed as higher risk, can offer less security, have limited track records and are usually too small to access public equity or bond markets economically, so a gap arises between the finance they need and what lenders and investors will readily provide. It is addressed through sources such as business angels, venture capital, crowdfunding and supply-chain finance. Options A, B and D are incorrect.