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Sample Question 4
Accpro is a leading tuition provider for professional accountancy qualifications. It has decided to replace its old accountancy software (tuition fee records only) and with a new one. The new system will maintain student records, tuition providers’ fees, exam fee payments, and analysis of information. The new system was purchased from the market and has only been live for just over a week. It was not run in parallel with the old system because Accpro’s finance director deemed that a parallel run would have been too expensive and disruptive to its operations. The head of Accpro’s internal audit department offered to conduct a post-implementation review of the system to confirm that user needs are being satisfied, but Accpro’s finance director declined this offer. He argued that any problems with the new system will quickly become apparent after it goes live. Classify which of the following are limitations of conducting a post-completion audit. Select ALL that apply:
A. Sufficient resources may not be allocated to the task of completing PCA. B. PCA can be time-consuming and costly to complete. C. If undertaken by the managers of the project, they may claim credit for all that went well and blame external factors for everything that didn’t. D. It can be used to blame the directors rather than learn from past mistakes.
Answers: A, B, C, D
Sample Question 5
Accpro is a leading tuition provider for professional accountancy qualifications. It has decided to replace its old accountancy software (tuition fee records only) with a new one. The new system will maintain student records, tuition providers’ fee, exam fee payments and analysis of information. The new system was purchased from the market and has only been live for just over a week. It was not run in parallel with the old system because Accpro’s finance director deemed that a parallel run would have been too expensive and disruptive to its operations. The head of Accpro’s internal audit department offered to conduct a post-implementation review of the system to confirm that user needs are being satisfied, but Accpro’s finance director declined this offer. He argued that any problems with the new system will quickly become apparent after it goes live. Evaluate the argument put forward by Accpro’s finance director for refusing to have a post-implementation review and identify the statements that support his point of view. Select ALL that apply:
A. This system is too important to the efficient running of Accpro to dispense with a postimplementation review. B. It is possible that many of the results that would have been obtained from a formal review will come to light if users are dissatisfied. C. The system is extremely important to Accpro’s operations and its control over cash. D. The system is a standard package, which reduces the risks of not conducting a review.
Answers: D Explanation: A B and C provide arguments in favor of post-implementation review.
Sample Question 6
Identify which of the following are ADVANTAGES of Post-Completion Audit (PCA). Select ALL that apply:
A. It decreases the frequency of project termination for ‘bad projects’. B. It improves the quality of decision-making. C. It abandons all under-performing projects by identifying the reasons for the under-performance. D. It highlights the reasons for successful projects. E. It provides a means of improving control mechanisms.
Answers: B, D, E B - It improves the quality of decision-making by providing a mechanism whereby past experience can be made readily available to decision-makers. D - It highlights the reasons for successful projects, which may be important in achieving greater benefits from future projects. E - It provides a means of improving control mechanisms by formally highlighting areas where weaknesses have caused problems. A - It increases the frequency of project termination for ‘bad projects’. C - It enables speedy modification of under-performing/over-performing projects by identifying the reasons for the under- or over-performance.
Sample Question 7
Please fill in the blanks using words from below the text:A post-completion _______ can be defined as an "objective ________ assessment of the success of a capital project in relation to a _______. It covers the whole life of a project and provides feedback to managers to aid the ________ and control of future projects."1: implementation2: control3: completion4: independent5: autonomous6: feasibility7: Plan8: audit
Answers: 1: audit; 2: independent; 3: plan; 4: implementation. A post-completion audit can be defined as an "objective independent assessment of the success of a capital project in relation to a plan. It covers the whole life of a project and provides feedback to managers to aid the implementation and control of future projects." The PCA reviews the cash flows from the project after the project has finished or sometimes during the life of the project. The aim is to identify any variances from the original budget and, particularly, to discover the causes of those variances.
Sample Question 8
Primed is a private medical college that is constructing a new block to offer additional admission seats for the MBBS qualification. ConstructAll has the contract for constructing the new block in 10 months’ time. Normally such projects take 14 months but ConstructAll has committed to put in extra workforce and finish the work in 10 months. Classes are going to commence by the last week of month 11. The project has no contingency plan. ConstructAll has not given any raises to its employees for two years, so some of them are considering going on strike. Which of the following is/are potential risks to the successful completion of the project? Select ALL that apply:
A. The commencement of classes might be cancelled due to low admissions. B. The administration of the college may not remain interested in offering increased admissions. C. 10 months might prove to be an unrealistic deadline commitment. D. The project may be suspended due to any unforeseen labour strike problem
Answers: C,D Explanation: These are both directly related to the construction process.
Sample Question 9
Eduexc is a public sector university that is constructing a new block for offering additional postgraduate qualifications. The board of directors of the university want to have strict control on the capital expenditure on this large project and have asked the accountant to submit periodic reports on the progress and cost. Which ONE of the following will NOT be data included in a capital expenditure progress and cost report for the new building?
A. Estimated cost to complete and estimated final over- or under-expenditure. B. Budgeted cost of the project, date started and scheduled completion date. C. Estimated depreciation method and useful life. D. Cost and over- or under-expenditure to date. E. Estimated completion date and details of penalties, if any.
Answers: C Explanation: The estimated depreciation method and useful life are considered post-completion. These factors will not be considered during the development process.
Sample Question 10
TelNet Co is a leading telecommunications company in country C. It is planning to offer internet services to its customers via a small portable USB device. The management of TelNet commissioned some market research to assess the key design features of the device that customers require. Then, the product design was created and a trial product produced. This trial product has gone into testing for consumer feedback. This activity would take place within which stage of implementation of the new project and its control processes?
A. The conceptual stage B. The development stage C. The control stage D. The operating stage
Answers: B Explanation: B - The development stage is where the project team needs to check that the concept meets customer requirements. This can be achieved by trial product testing and subsequent consumer feedback. A - The conceptual stage is where the new product, service, or process that is the focus of the project is worked on specifically. C - Control continues even after the initial manufacturing/operating stage has ended. D - When the product, service, or process has been developed and any design problems have been addressed, the next stage is where the new product, service, or process is launched.
Sample Question 11
In order for it to succeed, there are several stages in project implementation and control.Drag and drop the following stages in the correct order for the implementation of a new project and its control processes:1: Construction and initial manufacturing stage2: Conceptual stage3: Control stage4” Development stage
Sample Question 12
The System Development Life Cycle (SDLC), sometimes called the System Project Life Cycle (SPLC), has six main stages. Place the stages of implementation of a new project in the correct order:1: Review2: Implementation3: Analysis4: Design5: Development6: Planning
Answers: Bottom of Form
Planning Analysis Design Development Implementation Review
Sample Question 13
BDD is a leading tuition provider for professional accountancy qualifications. One of the critical success factors (CSFs) for BDD is to improve student satisfaction. Mr. Ben, the management accountant and a former student of BDD, is looking to measure its performance in a quantifiable way. Which of the following indicators would BEST suit the CSF identity? Select ALL that apply:
A. Maximization of BDD’s owner’s wealth. B. A decrease in the monthly number of complaints from students. C. An increase in positive student feedback. D. An increase in market share. E. The number of students. F. BDD’s gross profit percentage.
Answers: B, C, D All three factors are in line with the target of improving student satisfaction.
Sample Question 14
What is the meaning of having a satisficing strategy in an organisation?
A. Maximization of shareholders’ wealth B. Maximization of performance indicators satisfied C. Maximization of shareholders satisfied D. Maximization of stakeholders satisfied
Answers: B Explanation: A satisfactory strategy means that no performance indicator is maximized but, instead, many are satisfied.
Sample Question 15
Which of the following features can distinguish a not-for-profit organization from profit-maximizing organizations? Select ALL that apply:
A. They do not have external shareholders providing risk capital for the business. B. They do not distribute dividends, so any profit or surplus that is generated is retained by the business as a further source of capital. C. Their objectives usually include some social, cultural, philanthropic, welfare or environmental dimension. D. They offer a product that no other major organisation offers.
Answers: A, B , C Any organization that does not pursue profit as an objective is a not-for-profit organization. They usually describe their profit as a ‘surplus’ rather than a profit. The type of products offered is not a factor making an organisation not-for-profit.
Sample Question 16
Steel Co, a construction company, has won a contract with the government of Country C to build a new train line for within-city commuting. Their aim is to provide high-class travelling facilities to lowincome people. Currently, these people only have the option of using a bus for travelling within the city. However, the opposition party in Country C has protested that the plan is a favour given by the government to Steel Co rather than actually being beneficial to low-income people. Some people will suffer because their land and houses will be damaged or taken over on the construction route. As a result, the government has specified a range of conditions on the contract. Which of the following is the MOST likely to address the needs of less wealthy people if the project is successful?
A. The government will pay the fair value of the property to people whose houses are on the specified train route and will, therefore, be taken over. B. The train will be fuel-efficient and will have less than half of the carbon emissions of buses accommodating the same number of people. C. The ticket price charged will be half of the on-going rate for traveling via bus on the same routes. D. Steel Co will develop the road infrastructure of some prescribed areas of the city at a subsidized price.
Answers: C Explanation: C - This will decrease their traveling cost and time. A - This is compensation for property acquired rather than fulfilling the needs of less wealthy people. B - This is more concerned with protecting the environment and will have little impact on less wealthy people. D - This will reduce the profits of big business but will have little impact on less wealthy people.
Sample Question 17
What sort of performance measure might be set if a company wishes to measure the quality of its product? Select ONE correct statement:
A. The number of defective products produced. B. The number of staff leaves. C. The rate of staff turnover. D. The profit per unit of product.
Answers: A Explanation: The number of defective products would indicate if the product quality has reduced, improved or stayed the same. Fewer defects would mean better quality. Staff leaves and staff turnover relate to staff efficiency and satisfaction at work. Profit per unit would be more of a financial measure for the company.
Sample Question 18
Care is public sector hospital. Its directors are working on evaluating its performance and are considering different indicators for this purpose. Which of the following statements is/are TRUE for performance indicators for public sector organisations? Select ALL that apply:
A. The concept of profitability is most important in public sector organizations. B. Market share can be used as a performance indicator for public sector organizations. C. Return on assets may not be an appropriate indicator as there may be a difficulty in measuring its value. D. Public sector entities tend to be risk-averse because of the political repercussions of failure.
Answers: B, C, D B - Gaining market share must be seen as a long-term goal for entities to ensure outlets for their products and services and to minimize competition. D - Public sector entities tend to be risk-averse because of the political repercussions of failure and the fact that taxpayers, unlike shareholders, do not have the option to invest their money in less (or more) risky ventures. A - The concept of profitability is not a priority in most public sector organizations.
Sample Question 19
Sportco has just completed one year of manufacturing and selling sports goods. Its products are sold through its own stores and online business. The directors of Sportco plan to use return on assets (RoA) as their main performance indicator. Identify the DISADVANTAGES of using return on assets as a performance indicator. Select ALL that apply:
A. RoA is an accounting measure calculated by dividing annual profits by the average net book value of assets. B. RoA ignores the time value of money. C. The profit used in the calculation of RoA may be distorted due to the underlying depreciation policy. D. RoA gives no indication of how the assets were financed. E. RoA considers the net book value of assets rather than their fair value.
Answers: A,B,C,D,E Explanation: B - RoA ignores the time value of money, although this may be of minor concern when inflation is very low. C - RoA is subject to the distortions inevitable when profit, rather than cash flows, is used to determine performance. Distorting factors for interpretation and comparison purposes include depreciation policy, inventory revaluations, write-off of intangibles such as goodwill, etc. D - A company could have a high ROA but still be in financial trouble because all the assets were paid for through loans. E - If there is a large discrepancy between the carrying and fair value of the assets, the ratio could provide misleading numbers. A - This is the formula of RoA, not a disadvantage.
Sample Question 20
Cap Co manufactures and sells sports goods. Its products are distributed through a multi-channel network comprising of its own stores and online business, franchises and retail partners. The directors of Cap Co use profitability as their main performance indicator. Identify the DISADVANTAGES of using profitability as a performance indicator by Cap Co. Select ALL that apply:
A. It will not provide a systematic explanation as to why one business sector of Cap Co has more favourable prospects than another. B. It is remote from the actions that create value for Cap Co. C. The inputs to the measure may vary substantially between Cap Co and its competitors. D. It does not provide enough insight into the dynamics and balance of Cap Co’s individual business units and the balance between them.
Answers: A, B, C, D Explanation: Profitability may be defined as the rate at which profits are generated. It is often expressed as profit per unit of input (e.g. investment). However, profitability limits an entity’s focus to one output measure – profit. It overlooks quality, and this limitation must be kept in mind when using profitability as a measure of success.
Sample Question 21
Rose Co manufactures and sells cutlery and kitchen appliances. For many years, it has been recognized as a successful company and has become a household name. The products are distributed through a multi-channel network comprising its own stores and online business, franchises, and retail partners. Identify which of the following is/are financial objectives for Rose Co. Select ALL that apply:
A. Rose Co has a target to increase its return to investors by 20% this year. B. Rose Co-directors plan to hold the highest market share in the year 20X8. C. Rose Co wants customer complaints to reduce to half of the current level. D. Rose Co-directors plan to improve the efficiency of operating cash flows by 15%.
Answers: A, D Explanation: In order to achieve their overall objectives, companies should set specific targets, financial and nonfinancial, in order to both communicate direction and measure performance. Returns to investors and cash generation are financial objectives whereas market share and customer satisfaction are nonfinancial objectives.
Sample Question 22
Governments may use interest rates to control inflation.Complete the following sentence for government control of inflation:(Options can be used more than once)Increasing interest rates makes it more ______for profit-making entities to borrow. It also makes borrowing more ________ for consumers, who then have less to spend. This will help to push prices _________ .1: down2: up3: expensive4: cost-saving
Answers: 1: expensive; 2: expensive; 3: down. Increasing interest rates makes it more expensive for profit-making entities to borrow. It also makes borrowing more expensive for consumers, who then have less to spend. This will help to push prices down.
Sample Question 23
Which ONE of the following is NOT a key characteristic of not-for-profit organizations?
A. Revenue orientation for different customers. B. Operate for purposes other than to provide goods or services at a profit. C. Transparency in the organization’s mission and finances. D. Receive significant contributions from providers who do not expect returns.
Answers: A Organizations such as charities, trade unions and associations (such as accountancy bodies) are not run to make profits but to benefit prescribed groups of people. For example, the primary objective of a charity is to pursue whatever charitable objectives it was set up for.
Sample Question 24
Which ONE of the following is NOT an example of ways natural monopolies are regulated to ensure that the public are not the victims of the monopoly power these companies?
A. Disallowing them from making products with higher profit margins. B. Capping the selling process. C. Taxing super-profits. D. Applying a limit to the profits these organisations are allowed to make.
Answers: A Explanation: Some organizations are themselves natural monopolies and are often regulated in order to ensure that the public is not the victims of the monopoly power these companies enjoy. This regulation can take many forms but can include the capping of the selling process, taxation of super-profits, or simply a limit on the profits these organizations are allowed to make.
Sample Question 25
Please fill in the blanks:A value for money audit is defined as a/an ________into whether proper arrangements have been made for securing _______, efficiency and ________ in the use of ______ .1: economy2: research3: resources4: effectiveness5: funds6: audit7: investigation
Answers: Value for money audit is defined as an investigation into whether proper arrangements have been made for securing economy, efficiency, and effectiveness in the use of resources. Value for money audits can be conducted in the public sector but these concentrate on monetary costs rather than benefits.
Sample Question 26
Star Airport is situated in country A and its board of directors has produced a development plan. The plan relates to the development of Star Airport and its forecast passenger growth for the next two decades. The board proposes that future development of the airport will be phased and gradual in order to avoid unexpected consequences for the local communities and industry. Classify the following as financial and non-financial objectives for Star Airport:Reduce the visual and audible impacts of the operation of the airport on the local environment to a minimum Ensure that gearing levels do not exceed 30% Improve land-based access to the airport Ensure that the airport does not run at a loss Increase employment opportunities for people living close to the airport
Answers: Reduce the visual and audible impacts of the operation of the airport on the local environment to a minimum Non-financial Ensure that gearing levels do not exceed 30% Financial Improve land-based access to the airport Non-financial Ensure that the airport does not run at a lossFinancial Increase employment opportunities for people living close to the airport Non-financial
In order to achieve their overall objectives, companies should set specific targets, financial and nonfinancial, in order to both communicate direction and measure performance.
Sample Question 27
The Highway Company (THC) was considering two options for a new highway connecting two cities. Route 1 involved cutting a channel through an area designated as being of special importance because it is the natural habitat of the national animal, now considered an endangered species. The alternative was Route 2, which would involve the compulsory purchase and destruction of Mr. Dan’s factory. Mr. Dan threatened legal action if Route 2 was chosen as it would cause significant damage to his business and loss of jobs for 100 employees. On the other hand, a local environmental pressure group, ‘Endangered Species’, was outraged at the plan to choose Route 1. It criticized THC for ignoring the sustainability implications of the decision and accused the company of profiting at the expense of the environment. The project for Route 1 has a higher NPV than Route 2. THC is having trouble selecting the final route for the new highway.Which of the following statements concerning stakeholders of THC is/are CORRECT? Select ALL that apply.
A. All of THC’s shareholders would be impartial to both routes as long as the route is profitable. B. THC’s shareholders will be unanimously in favour of the construction of Route 1. C. THC is likely to have a poor reputation with environmental activists already, so investment in Route 2 is unlikely to damage it any further. D. If THC chooses Route 1, it would be less sustainable but more favourable to shareholders and the stakeholders in the factory.
Answers: D Explanation: D - Route 1 would be less environmentally sustainable because of harm to endangered species but more favorable to shareholders as it has higher NPV and the stakeholders in the factory will have their jobs secured. A, B - At least some of THC’s shareholders will be worried that any poor publicity received could impact its ability to win future contracts. C - While THC may (or may not) already have a poor reputation with environmental activists, investment in Route 1 could damage it further.
Sample Question 28
The finance ministry of country D is analyzing the impacts of an increase in the inflation rate from 5% to 11% within 3 years. So far they have considered the following trends as a result of this inflation. Which of the following is/are a TRUE reflection of the inflation rate changes taking place in the economy?
A. Some manufacturing organizations have decreased their prices because the demand for products has lowered. B. As a result of the increase in inflation and therefore the interest rate, the demand for borrowing has increased. C. The lower exchange rate resulting from high inflation has lowered export prices
Answers: A Less demand in the economy may encourage producers to lower prices in order to sell. This could be achieved by squeezing profit margins and/or wage levels. New borrowing is deferred by high interest rates and so demand will fall. Higher inflation means a higher exchange rate, which will raise export prices and thereby threaten sales.
Sample Question 29
The ministry of finance of Beta country is making a budget for their next fiscal year. The main challenge being faced is that the inflation rate has fluctuated a lot recently. The finance minister predicts that the rate of inflation will rise on average by 8% during the next year. The interest rate may fluctuate between 6% and 9.5%. Which of the following is/are TRUE regarding this increase in inflation rate? Select ALL that apply:
A. An inflation rate under 10% is considered to be acceptable, not harmful. B. Traders of Beta may delay purchases because they predict lower prices later. C. There will be a better distribution of wealth in Beta. D. Fluctuations in the inflation rate make it difficult for entrepreneurs in Beta to predict the economic future and accurately calculate prices and investment returns.
Answers: D D - Wide fluctuations in the inflation rate make it difficult for entrepreneurs to predict the economic future and accurately calculate prices and investment returns. This uncertainty handicaps planning and production. A - If the rate of inflation is low, the effects may be beneficial to an economy. There is an agreement that inflation above 5% is harmful – worse still if it is accelerating. B - People may bring forward purchases because they fear higher prices later. C - People on fixed incomes or those lacking bargaining power will become relatively worse off because their purchasing power falls.
Sample Question 30
Changes in interest rates affect the economy in many ways.Insert the words below to complete the statement:If the interest rate increases, the exchange rate _______ , i.e. the inflow of foreign funds _________demand for the domestic currency and so pushing up the _______ . This has the benefit of _________ import prices and thereby bearing down on domestic ________ . However, it makes exports more ________ and possibly _________ to sell. The _________ term effect on the balance of payments could be beneficial or harmful depending on the elasticity of demand and supply for traded goods.1: longer2: easier3: increasing4: decreases5: inflation6: exchange rate7: increases8: expensive9: decreasing10: shorter11: harder
Answers: If the interest rate increases, the exchange rate increases, i.e. the inflow of foreign funds increasing demand for the domestic currency and so pushing up the exchange rate. This has the benefit of decreasing import prices and thereby bearing down on domestic inflation. However, it makes exports more expensive and possibly harder to sell. The longer-term effect on the balance of payments could be beneficial or harmful depending on the elasticity of demand and supply for traded goods.
Sample Question 31
In APV, debt finance benefits a project because of the associated tax shield. If a project brings about an increase in the borrowing capacity of the firm, it will increase the potential tax shield available. On which value will the tax shield be based if the actual debt raised by a company is $500,000 but the investment is believed to add $700,000 to the company's debt capacity? Fill in the blank: $ ____________
Answers: $700,000 The present value of the tax shield (tax relief on interest) should be based on the project's theoretical debt capacity and not on the actual amount of the debt.
Sample Question 32
Adjusted Present Value (APV) consists of two different elements, i.e. the investment element and the financing element. The present value of the costs and benefits associated with a financing package is calculated for the financing element. Select ALL of the following that are side-effects of financing:
A. Pre-tax issuance costs of the finance. B. Tax allowable deduction on the finance cost paid on loans used. C. Government grants. D. Tax relief on subsidized loans.
Answers: B,C,D After-tax issuance costs of the finance needed for the project are a side-effect of financing.
Sample Question 33
If the business risk of a new project differs from the entity's existing business risk but the gearing is held constant, then a risk-adjusted WACC should be calculated by recalculating the cost of equity to reflect the business risk of the new project. Arrange the following in the correct order as per the steps in the calculation of risk-adjusted WACC:1: Evaluate the project by calculating an NPV2” Find a quoted company in the same business area as the project and find its equity beta3: Degear the equity beta to get an ungeared asset beta4: Readjust the asset beta to reflect the project gearing levels - regear the beta5: Use this Keto find the WACC6: Use beta to find Ke using CAPM
Sample Question 34
Neon Co is a television manufacturing company. It is planning to start a project to manufacture a new television. Why should Neon Co make sure that this new project is in the same risk class as existing operations before using the WACC as the discount rate?
A. If Neon Co uses the WACC of existing operations to evaluate the new project without regarding the risk class of the project, the risk of the company will increase over time. B. Only projects with risk similar to that of present operations can result in positive NPV for Neon Co. C. If the new project will decrease risk, Neon Co should reject it. D. A new project that is in a different risk class must be analysed using the WACC of the firm's existing operations.
Answers: A Explanation: The WACC of a company reflects the level of risk and WACC is only the appropriate discount rate if the intended investment is a replica of the company’s existing activities in that it has the same level of risk.
Sample Question 35
The weighted average cost of capital (WACC) includes multiple factors in its calculation. What will be the impact of a decrease in the corporation tax rate on the calculation of WACC? Select ONE correct answer.
A. It will decrease the WACC of a firm with no debt in its capital structure. B. It will decrease the WACC of a firm with debt in its capital structure. C. It will increase the WACC of a firm with debt in its capital structure D. It will increase the WACC of a firm with debt and equity in its capital structure. E. It will not affect the calculation of WACC of a firm with debt in its capital structure.
Answers: C Explanation: The WACC is equal to the firm's embedded debt cost multiplied by (1 - tc). As the tax rate will decrease, the tax allowable deduction will also decrease, thereby increasing the WACC.
Sample Question 36
The company WACC is often used as a discount rate when using net present value or internal rate of return calculations. Select THREE conditions that have to be met when using WACC as a discount rate:
A. If the capital structure changes, the weightings in the WACC will also change. B. The new investment does not carry a different business risk profile to the existing company's operations. C. The discount rate of the intended investment is a replica of the company’s existing activities. D. The company is completely equity-financed.
Answers: A,B,C Explanation: The capital structure has to be constant. If the business risk of the project is different, the CAPM would suggest that the required return of investors should be different. The WACC of a company reflects the level of risk and WACC is only an appropriate discount rate if the intended investment is a replica of the company’s existing activities in that it has the same level of risk.
Sample Question 37
A portfolio manager at Capital Asset Management Services, a well-known investment manager in the USA, is constructing a new equity portfolio consisting of a large number of randomly chosen stocks. Of the options below, select the MOST accurate statement with regard to the effect on the expected levels of systematic and unsystematic risk as the number of stocks in the portfolio increases: Systematic UnsystematicA Increases Remains the same B Decreases Increases C Remains the same Decreases D Remains the same Remains the same
A. Option A B. Option B C. Option C D. Option D
Answers: C Explanation: As randomly selected securities are added to a portfolio, the unsystematic (specific) risk decreases and the systematic (market) risk remains the same. Systematic (market) risk cannot be diversified away, hence it cannot increase or decrease. The unsystematic risk (specific) can be diversified away, hence it will increase or decrease based on the size of the portfolio.
Sample Question 38
Delta Co has hired a recently qualified CIMA Accountant. He is using an SML to determine the feasibility of a project. What should the status of the project be if its beta and IRR coordinates plot above the SML?
A. The project should be accepted. B. The project should be rejected. C. It will depend on the NPV of the project. D. Further information will be required for a decision.
Answers: A Explanation: The security market line (SML) is a line that graphs the systematic, or market, risk versus return of the whole market at a certain time and shows all risky marketable securities. The SML essentially graphs the results from the capital asset pricing model (CAPM) formula. The x-axis represents the risk (beta), and the y-axis represents the expected return. The market risk premium is determined from the slope of the SML.
Sample Question 39
Which of the following is TRUE if the estimated cost of equity of a project is calculated using the security market line SML approach? Select ALL that apply.
A. SML shows the relationship between the level of systematic risk and the corresponding required return. B. SML is the representation of the capital asset pricing model. C. SML applies only to firms with stable dividend growth rates. D. SML estimate is adjusted for risk. E. To implement this approach, estimates of a market risk premium and a beta coefficient have to be made. F. The quality of the estimate from the SML approach is sensitive to the quality of the estimates of the variables in the model.
Answers: A,B,D,E,F Explanation: The security market line (SML) is a line that graphs the systematic, or market, risk versus return of the whole market at a certain time and shows all risky marketable securities. The SML essentially graphs the results from the capital asset pricing model (CAPM) formula. The x-axis represents the risk (beta), and the y-axis represents the expected return. The market risk premium is determined from the slope of the SML.
Sample Question 40
What will be the risk-free rate of interest if the required return from individual security is 12.08%, the return on the market portfolio is 10.1%, and the Beta factor of an individual security is 2.8. Fill in the blank: __________ % (Answer with a round figure)
The shares of Root Co have a beta of 1.8. If the risk-free rate is 3% and the risk premium on the market portfolio is 8%, the required return using CAPM on Root's shares will be: Fill in the blank:_________ %
Answers: 17.4% Explanation: Required return = risk free rate + risk premium ke = Rf + [Rm – Rf] ß ke = 3% + [8%] * 1.8 = 17.4% Risk premium on market portfolio (market premium) = the difference between Rm & Rf = Rm - Rf = 8% NOT (8%-5%)
Sample Question 42
Delta Co-directors have calculated its Beta factor to be 0.6. A Beta (ß) of 0.6 means that:
A. The total return on the shares is 60% of the stock market average. B. The total risk of the company is 60% of the stock market average. C. The market risk of the shares as regards economic fluctuations is 60% of the stock market average. D. The non-systematic risk of the company is 60% of the stock market average.
Answers: C Explanation: Beta is a relative measure of systematic risk, comparing the systematic risk of the company or investment being considered with the average level of systematic risk in the stock market as a whole. If Beta = 1, the shares have the same systematic risk as the stock market average. The increase or decrease in this figure is with respect to the stock market average.
Sample Question 43
The risk that a shareholder of a company requires an extra return for (risk premium) is:
A. The systematic + unsystematic risk of the share B. The unsystematic risk of the share C. The systematic risk of the share D. The systematic – unsystematic risk of the share
Answers: C Explanation: The company carrying out the investment does not need to be well-diversified. The key issue is whether or not the ultimate shareholders have a sufficiently diversified portfolio to minimise the systematic or market-related risk.
Sample Question 44
Complete the sentence below as per the risks associated with an investment: By building a portfolio of investments, __________ risk can be reduced or diversified away. __________ risk is not reduced in this way, so will be present in all portfolios. Diversification reduces portfolio risk to a ___________ . If we can measure the ____________ risk of a company or investment, the CAPM will enable us to calculate the level of required __________for a well-diversified investor who is not subject to ___________ risk.1: Systematic2: Zero3: Unsystematic4: Return5: Minimum6: Risk
Answers:
1. unsystematic; 2. Systematic; 3. minimum; 4. systematic; 5. return; 6 unsystematic. By building a portfolio of investments, unsystematic risk can be reduced or diversified away. Systematic risk is not reduced in this way, so it will be present in all portfolios. Diversification reduces portfolio risk to a minimum. If we can measure the systematic risk of a company or investment, the CAPM will enable us to calculate the level of required return for a well-diversified investor who is not subject to unsystematic risk.
Sample Question 45
AB Constructions is a building developer based in Spain. For its next investment, the company is considering purchasing a large piece of land in the suburbs of Madrid. The land is currently owned by the local government, who would like AB Constructions to build both residential apartments and office space. AB Constructions has calculated that the net present value (NPV) of the project is negative. However this would be the first contract with the local government, and, if the company delivers on time, the government will offer AB Constructions more investments to build, and also the rates for the land will be more preferential. Which ONE of the following real options is included within the construction project?
A. Option to delay B. Option to follow on C. Option to return D. Option to abandon
Answers: B Explanation: Option to follow on - usually when the project has a positive NPV. However a project with a negative NPV could provide the business with the opportunity to invest in other, more profitable projects in the future. Option to abandon - when a project requires a large capital investment and has an uncertain outcome. Option to delay - to delay the start time of a project. There is no such thing as an option to return according to real options theory.
Sample Question 46
Which ONE of the following is NOT a category of real option?
A. The abandonment option B. Timing options C. The commitment option D. Strategic investment options E. Follow-on options
Answers: C Explanation: For investment decisions, there are three option types to be considered: A - The abandonment option (financial put option). B - Timing options (financial call option) – sometimes referred to as "wait and see options". D, E - Strategic investment options (financial call option) – sometimes referred to as "follow-on options".
Sample Question 47
The NPV approach to investment appraisal makes two assumptions. Which TWO of the following are NOT assumptions in the NPV approach to investment appraisal?
A. A project is reversible B. A project is irreversible C. A project can be delayed D. A project cannot be delayed
Answers: A,C Explanation: The assumption that a project is reversible implies that if the project does not work out, the original investment can be recovered and applied to a new project. This is flawed, as in most significant projects the original investment will either be wholly or partly irreversible. In some instances, it may not be possible to delay an investment decision, but in the majority of cases, a delay is possible – although there may be costs associated with delay.
Sample Question 48
Gamma Co’s directors are studying call and put options to understand the details of real options. Complete the sentence below as per Gamma Co’s requirements: A put option is an option to __________ a specified asset at a specified exercise price on or _________ a specified __________ date. 1: sell 2: befor 3: eafter 4: expiry 5: buy 6: exercise
Answers: 1: sell; 2: before; 3: exercise.
Sample Question 49
Light Co is undertaking a project that involves a $12 million investment today and will generate cash savings in perpetuity. Directors believe that the cash savings (in perpetuity) at the end of each year are $1.5m certain. The relevant discount factor for the project is 10%. Using certainty equivalents, what is the certainty of annual cash savings required for the project to break even? (Answer to two decimal places)__________________
Sample Question 50
Gamma Co is undertaking a project that involves a $30 million investment today and will generate cash savings in perpetuity. Directors believe that the cash savings (in perpetuity) at the end of each year are 90% certain. The relevant discount factor for the project is 12%. Using certainty equivalents, what is the annual cash saving required for the project to break even?$ ______________ m
Sample Question 51
The Certainty Equivalent Method is an approach to dealing with risk in a capital budgeting context. It is used as an alternative to using higher discount rates to incorporate risk. The following data is for a potential project by Orange Co. Cashflows are ($20m), $18m and $15m for Year 0,1 and 2, respectively. The certainty equivalent factor is 1.00, 0.95, and 0.90, respectively. The risk-free discount rate used by the company is 10%. Calculate the NPV of the project using the following data as per the certainty equivalent method.
A. $6.08m B. $6.69m C. $10.60m D. $13.00m
Answer: B
Sample Question 52
Alpha Co is evaluating a new investment project for which it will have to invest in a non-current asset worth $1,200,000. The cash flows from the project for the next four years will be as follows: Sales = $2,000,000 per year Costs = $1,200,000 per year Tax rate of the company for the entire duration of the project will be 25%, and the asset will be depreciated on a straight-line basis over the life of the project. The cost of capital of Alpha Co is 8%. What is the percentage sensitivity of the discount rate to the project if the IRR of the 2nd project is 20%?
A. 7% B. 12% C. 25% D. 17%
Answers: Net cash flow ($) (1,200)675 675 675 675 DF @ 20% 1 0.833 0.694 0.579 0.482 PV of cash flow ($) (1,200)562.275 548.45390.825 325.35 NPV = $546,900 IRR = R1 + (R2 – R1) × NPV1/(NPV1 – NPV2) IRR = 0.08 + (0.20 – 0.08) × $1,035.6/($1,035.6 – $546.9) IRR = 0.334 or 33% The IRR of the project should be calculated, and the difference between the existing cost of capital and the IRR then indicates the sensitivity to the discount rate. Sensitivity to the discount rate = 33 – 8 = 25%
Sample Question 53
Alpha Co is evaluating a new investment project for which it will have to invest in a non-current asset worth $1,200,000. The cashflows from the project for the next four years will be as follows: Sales = $2,000,000 per year Costs = $1,200,000 per year Tax rate of the company for the entire duration of the project will be 25%, and the asset will be depreciated on a straight-line basis over the life of the project. The cost of capital of Alpha Co is 8%. What is the approximate IRR of the project, assuming the second discount rate of 20%?
A. 15% B. 20% C. 25% D. 33%
Answers: NPV at discount rate of 8% is taken from the question 9, i.e. Total NPV = $1,035,600 (NPV 1) Net cash flow ($) (1,200)675 675 675 675 DF @ 20% 1 0.833 0.694 0.579 0.482 PV of cash flow ($) (1,200)562.275 548.45390.825 325.35 NPV = $546,900 IRR = R1 + (R2 – R1) × NPV1/(NPV1 – NPV2) IRR = 0.08 + (0.20 – 0.08) × $1,035.6/($1,035.6 – $546.9) IRR = 0.334 or 33%
Sample Question 54
Alpha Co is evaluating a new investment project for which it will have to invest in a non-current asset worth $1,200,000. The cashflows from the project for the next four years will be as follows: Sales = $2,000,000 per year Costs = $1,200,000 per year Tax rate of the company for the entire duration of the project will be 25%, and the asset will be depreciated on a straight-line basis over the life of the project. The cost of capital of Alpha Co is 8%. What is the percentage sensitivity to tax rate on the whole project? ________ % (answer with a round figure)
Answers: 250% Explanation: Sensitivity to tax rate: = (NPV/PV of cash flows affected by the estimate of tax rate) × 100% = [$1,035.6/(($200 – $75) × 3.312)] × 100% = 250% i.e. if the tax rate were to rise by 250%, the NPV would fall to zero.
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