CIMA F3 Sources of long-term funds: practice questions with answers

Question 1

Corran plc is making a 1 for 4 rights issue at a subscription price of $3.20 per share. Its share price immediately before the issue goes ex-rights is $4.00. What is the theoretical ex-rights price (TERP)?

1. A $3.36
2. B $3.60
3. C $3.80
4. D $3.84

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Answer: D. TERP = (market value of existing shares + cash raised) / total shares after the issue.

For every 4 shares held: (4 x $4.00) + (1 x $3.20) = $19.20, spread over 5 shares.

TERP = $19.20 / 5 = $3.84

Question 2

Assume a world with no taxes and perfect capital markets. Orrin Co is currently all-equity financed with a cost of equity of 11%. It plans to borrow at 5% and use the funds to repurchase shares, so that its debt to equity ratio becomes 1:2 by market value. According to Modigliani and Miller's theory, what will Orrin Co's cost of equity be after the change?

1. A 13.00%
2. B 13.25%
3. C 14.00%
4. D 16.50%

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Answer: C. MM (no tax), proposition 2: ke(g) = ke(u) + (ke(u) - kd) x D/E

ke(g) = 11% + (11% - 5%) x (1/2) = 11% + 3% = 14.00%

The rise in the cost of equity exactly offsets the benefit of cheaper debt, so the WACC stays at 11%: (2/3 x 14%) + (1/3 x 5%) = 11%.

Question 3

Qadir plc, a large listed company with a strong credit rating, needs to fund a seasonal build-up of inventory for about four months each year. The treasurer proposes issuing commercial paper. Which statement about commercial paper is correct?

1. A It is unsecured short-term debt, usually issued at a discount to face value by companies with good credit ratings
2. B It is secured on the company's assets and normally has a maturity of three to five years
3. C It pays a fixed annual coupon and is usually convertible into ordinary shares at the holder's option
4. D It is a committed bank facility that the company can draw on and repay at any time during its term

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Answer: A. Commercial paper is an unsecured promissory note with a short maturity (often 30–270 days), usually issued at a discount to its face value. Because it is unsecured, it is available mainly to large companies with good credit ratings, and it is often backed by a standby bank facility. It suits short-term needs such as seasonal working capital; it is one of the short-term debt instruments listed in the F3 syllabus alongside green finance.

Question 4

Holbeck Co, a private company, is joining a stock market and wants to raise a relatively small amount of new equity ($15 million) as cheaply as possible. Which method of issue is most suitable?

1. A An offer for sale to the general public at a fixed price
2. B A stock exchange introduction
3. C A placing, in which the shares are sold mainly to selected institutional investors
4. D An offer for sale by tender, in which investors bid for shares

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Answer: C. Ways to obtain a listing include an offer for sale (fixed price or tender), a placing and an introduction. A placing sells shares to a small number of institutional investors, so it is quicker and cheaper and suits smaller issues, although the shareholder base is narrower and initial liquidity may be lower. An introduction raises no new money, so it does not meet Holbeck Co's need for finance.

Question 5

According to the static trade-off theory of capital structure, why does a company have an optimal level of gearing below 100% debt?

1. A Shareholders do not demand a higher return for financial risk until gearing is very high
2. B Beyond some level, the expected costs of financial distress and agency costs outweigh the value of further tax relief on interest
3. C Managers prefer internal funds and use debt only after retained earnings have run out
4. D Without taxes, the company's WACC stays the same at every level of gearing

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Answer: B. MM with tax implies that value rises with every extra $1 of debt because of the interest tax shield. The static trade-off theory adds the costs of high gearing: direct and indirect costs of financial distress (lost customers and suppliers, forced asset sales, bankruptcy costs) and agency costs (restrictive covenants, monitoring). Company value is maximised where the marginal tax benefit equals the marginal expected cost of distress, which gives a target gearing ratio. Companies with stable cash flows and tangible assets can carry more debt than those with volatile cash flows and intangible assets.

Question 6

Which of the following statements about a Eurobond is correct?

1. A It is a bond that must be denominated in euros and issued within the eurozone
2. B It is a short-term money market instrument with a maturity of less than one year
3. C It is a bond issued outside the country of the currency in which it is denominated, usually sold through an international syndicate of banks
4. D It must be secured on the issuer's assets and registered with the central bank of the currency

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Answer: C. A Eurobond (international bond) is denominated in a currency other than that of the country or market in which it is issued, and is typically placed by an international syndicate with institutional investors in several countries. Large companies with good credit ratings use Eurobonds to raise long-term finance in a chosen currency (for example to match overseas assets), often at lower cost and with less regulation than a domestic issue.