CIMA F3 Financial policy decisions: practice questions with answers

Question 1

The board of Velmora plc, a listed manufacturer of packaging materials, is reviewing its financial objectives. According to corporate finance theory, which of the following is the most appropriate primary financial objective for Velmora plc?

1. A Maximise the wealth of its ordinary shareholders over the long term
2. B Maximise reported earnings per share in each financial year
3. C Maximise sales revenue growth, subject to a minimum level of profit
4. D Minimise the weighted average cost of capital in each financial year

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Answer: A. Shareholders own a listed company and bear its residual risk, so theory treats maximising shareholder wealth (the present value of future dividends and capital growth) as the primary financial objective. EPS targets, revenue growth and WACC minimisation are at best secondary objectives or measures, and each can conflict with value creation.

Question 2

A publicly funded hospital reports that the average cost of each completed hip-replacement operation has fallen from $9,200 to $8,700, with no change in clinical outcomes. Which element of value for money does this measure most directly demonstrate?

1. A Economy
2. B Effectiveness
3. C Equity
4. D Efficiency

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Answer: D. Not-for-profit organisations assess value for money using the 3 Es. Economy = buying inputs at the lowest cost for the required quality; efficiency = the relationship between outputs and inputs (here, cost per completed operation); effectiveness = achieving the intended outcomes. A fall in cost per operation with the same outcomes is an efficiency gain.

Question 3

Modigliani and Miller argued that, given the company's investment policy, dividend policy does not affect shareholder wealth. Which of the following assumptions is required for their dividend irrelevance argument to hold?

1. A Shareholders can create 'home-made dividends' by selling shares, with no taxes or transaction costs
2. B Shareholders value a certain dividend today more highly than an uncertain future capital gain
3. C Changes in dividends convey new information to the market about future earnings
4. D Shareholders form clienteles according to the tax rates they pay on dividends and gains

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Answer: A. MM's dividend irrelevance theory assumes a perfect capital market: no taxes, no transaction or issue costs, equal information for all, and a fixed investment policy. Under these conditions a shareholder who wants more cash than the dividend can sell shares, and one who wants less can reinvest, at no cost. The bird-in-the-hand view, signalling and clientele effects are all arguments that dividend policy is relevant because those assumptions do not hold.

Question 4

Hensall plc is considering offering shareholders a scrip dividend (new shares instead of a cash dividend) this year. Which of the following statements about a scrip dividend is correct?

1. A It increases the company's gearing compared with paying the same dividend in cash
2. B It lets the company retain cash, while shareholders who accept can increase their holdings without paying dealing costs
3. C It reduces the number of shares in issue and so increases earnings per share
4. D It must be accepted by every shareholder once it has been approved by the board

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Answer: B. A scrip dividend gives shareholders the choice of new shares instead of cash. For the company it conserves cash (useful when funding investment) and keeps gearing lower than a cash payout would. For shareholders it is a cheap way to reinvest, although the extra shares dilute EPS and those who take cash see their proportionate holding fall. It links the dividend decision with the financing decision.