Free CIMA F3 Practice Exam with Questions & Answers | Set: 11

Step 1 – Work out current gearing

Current values:

Equity = $80m

Debt = $20m

Total value VVV = 80 + 20 = $100m

So:

DE=2080=0.25\frac{D}{E} = \frac{20}{80} = 0.25ED​=8020​=0.25

Tax rate T=20%T = 20\%T=20% → after-tax cost of debt:

Kd(1−T)=6%(1−0.2)=4.8%K_d(1-T) = 6\%(1-0.2) = 4.8\%Kd​(1−T)=6%(1−0.2)=4.8%

Given cost of equity Ke=14%K_e = 14\%Ke​=14%.

Step 2 – Find the ungeared (asset) cost of capital KuK_uKu​

Use Modigliani–Miller with tax for equity:

Ke=Ku+(Ku−Kd)(1−T)DEK_e = K_u + (K_u - K_d)(1-T)\frac{D}{E}Ke​=Ku​+(Ku​−Kd​)(1−T)ED​

Substitute:

14=Ku+(Ku−6)×0.8×0.2514 = K_u + (K_u - 6)\times 0.8 \times 0.2514=Ku​+(Ku​−6)×0.8×0.25 14=Ku+0.2(Ku−6)14 = K_u + 0.2(K_u - 6)14=Ku​+0.2(Ku​−6) 14=1.2Ku−1.214 = 1.2K_u - 1.214=1.2Ku​−1.2 1.2Ku=15.2⇒Ku≈12.67%1.2K_u = 15.2 \Rightarrow K_u \approx 12.67\%1.2Ku​=15.2⇒Ku​≈12.67%

Step 3 – Re-gear the cost of equity for the new structure

New target mix: Debt : Equity = 40 : 60 ⇒

DE=4060=0.6667\frac{D}{E} = \frac{40}{60} = 0.6667ED​=6040​=0.6667

Reapply MM with tax:

Ke′=Ku+(Ku−Kd)(1−T)DEK_e' = K_u + (K_u - K_d)(1-T)\frac{D}{E}Ke′​=Ku​+(Ku​−Kd​)(1−T)ED​ Ke′=12.67+(12.67−6)×0.8×0.6667K_e' = 12.67 + (12.67 - 6)\times 0.8 \times 0.6667Ke′​=12.67+(12.67−6)×0.8×0.6667 Ke′≈12.67+3.56=16.23%K_e' \approx 12.67 + 3.56 = 16.23\%Ke′​≈12.67+3.56=16.23%

Step 4 – Calculate new WACC

New proportions:

E/V=60100=0.6,D/V=40100=0.4E/V = \frac{60}{100} = 0.6,\quad D/V = \frac{40}{100} = 0.4E/V=10060​=0.6,D/V=10040​=0.4 WACC′=0.6×16.23%+0.4×4.8%\text{WACC}' = 0.6 \times 16.23\% + 0.4 \times 4.8\%WACC′=0.6×16.23%+0.4×4.8% WACC′≈9.74%+1.92%=11.66%\text{WACC}' \approx 9.74\% + 1.92\% = 11.66\%WACC′≈9.74%+1.92%=11.66%

Answer: A. $129.6

Working

Current share price = $5.60

Growth for 3 years at 5% p.a.:

P3=5.60×1.053=5.60×1.157625=6.4827≈$6.48P_3 = 5.60 \times 1.05^3 = 5.60 \times 1.157625 = 6.4827 \approx \$6.48P3​=5.60×1.053=5.60×1.157625=6.4827≈$6.48

Conversion terms = 20 shares per $100 bond

Conversion value in 3 years:

Conversion value=20×6.4827=129.654≈$129.6\text{Conversion value} = 20 \times 6.4827 = 129.654 \approx \$129.6Conversion value=20×6.4827=129.654≈$129.6

So the expected conversion value per $100 bond is $129.6.

In CIMA F3, when selecting an appropriate source of finance, you match the type and maturity of finance to the purpose of the funds, and you must also respect any constraints such as debt covenants and target gearing. Here the company “is financed by debt and equity” and is already close to breaching a debt covenant if it increases the proportion of debt. That immediately rules out additional long-term borrowing such as a private placement of a bond (B) and also makes a bank overdraft (D) inappropriate: an overdraft is short-term, potentially repayable on demand, and is still debt, so it worsens gearing and covenant pressure.

The project is a major expansion programme, so it requires long-term, stable capital. F3 material emphasises that for a listed company needing substantial equity finance, a rights issue is usually the preferred mechanism: it raises new equity, does not increase financial risk, and allows existing shareholders to maintain their proportional ownership by taking up their rights.

“Retained earnings” (A) represent accumulated past profits already part of equity; they are not a mechanism for raising an immediate $800m of new cash for investment. Therefore, the most appropriate source of finance in this situation is a rights issue.

Regulations likely to hurt ZZZ most:

A. Minimum staff-to-client ratio – raises operating costs, particularly for a large operator.

B. Maximum price controls – directly restrict ZZZ’s ability to charge premium prices.

C. Monopoly controls forcing disposals – may force ZZZ to sell homes and shrink.

D is a one-off hit, and E is less of a threat to a high-quality provider.

 A – True. A special dividend can create expectations of similar future payouts, while a buyback is more clearly one-off.

 B – True. A repurchase can be interpreted by some investors as management having no positive-NPV projects, i.e. a possible negative signal about growth opportunities.

 C – False. The repurchase price is not automatically the open-market price; it may involve negotiation or a premium/discount.

 D – True. In many tax regimes, capital gains (from buybacks) are taxed more favourably than dividend income, so some shareholders may prefer repurchases.

 E – False. Even if approved, individual shareholders are usually free to choose whether or not to tender their shares.

Conversion value = (conversion ratio) × (share price).

Share price is expected to grow 5% p.a. from $4.50, so the conversion value rises each year. With a steadily rising price and no other constraints given, a rational bondholder delays conversion as long as possible among the dates offered, to maximise value.

So the most worthwhile of the dates listed is the latest one: 31 December 20X3.

Answer: C. 31 December 20X3

Once Division B is sold, Division A becomes heavily reliant on B as a major external customer. If the new owner reduces purchases or switches supplier, Division A’s volumes and viability are at risk. That makes:

C. Division A's going concern is highly dependent on its relationship with Division B – the main risk.

Profit before tax = $4.0m

Tax at 25% → earnings = $4.0m × (1 − 0.25) = $3.0m

For a takeover, the most relevant comparators are recent takeover P/E multiples in the same industry: 9–10x.

Minimum value = 3.0 × 9 = $27m

Maximum value = 3.0 × 10 = $30m

Answer: B. Minimum = $27m, maximum = $30m