I85PREP
⌘ K
ICAB PL Financial Management study materials
ICAB PL Financial Management study resources

ICAB PL Financial Management practice questions

One question at a time. Build your ICAB PL Financial Management understanding.

First 50 of 200 questions. Each one lists the choices, the correct answer, and an explanation. The checker at the top of this page saves progress in this browser when it is available.

Continue in the practice tool above to load more questions, 50 at a time.

Question 1Financial Management

A company has current assets of $480,000 and current liabilities of $300,000. What is its current ratio?

  1. 0.63
  2. 1.60 Correct answer.
  3. 1.80
  4. 2.40

Explanation

The current ratio divides current assets by current liabilities, so $480,000 divided by $300,000 equals 1.60. This measure shows how many dollars of short-term resources cover each dollar of obligations due within a year, and a figure comfortably above 1.0 generally signals adequate liquidity.

Question 2Financial Management

Which inventory costing method generally produces the highest cost of goods sold during a period of rising prices?

  1. Weighted average cost
  2. First-in, first-out
  3. Last-in, first-out Correct answer.
  4. Specific identification

Explanation

When prices are rising, the last-in, first-out method charges the most recent and therefore highest purchase costs against revenue first. That raises cost of goods sold and lowers reported profit compared with methods that assign older, cheaper costs to sales.

Question 3Financial Management

A firm issues a bond with a coupon rate of 6% when the market yield is 8%. The bond will most likely be issued at which price relative to par?

  1. Par
  2. A premium
  3. A price that cannot be determined
  4. A discount Correct answer.

Explanation

When the coupon rate is below the required market yield, investors will pay less than face value so that the total return matches prevailing yields. The bond therefore trades at a discount to par, and the gap narrows as maturity approaches.

Question 4Financial Management

Which of the following best describes the payback period method of investment appraisal?

  1. The ratio of average annual profit to average investment
  2. The discount rate at which net present value equals zero
  3. The present value of cash inflows divided by the initial outlay
  4. The time taken for cumulative cash inflows to recover the initial outlay Correct answer.

Explanation

The payback period simply measures how long it takes for cumulative cash inflows to equal the original investment. It ignores the time value of money and any cash flows arising after the payback point, which is its principal weakness.

Question 5Financial Management

A company has a dividend payout ratio of 40% and a return on equity of 15%. Using the sustainable growth rate formula, what is the approximate sustainable growth rate?

  1. 6.0%
  2. 12.5%
  3. 15.0%
  4. 9.0% Correct answer.

Explanation

The sustainable growth rate equals the retention ratio multiplied by return on equity. With a 40% payout the retention ratio is 60%, and 60% times 15% gives 9.0%, the rate the firm can grow without changing its capital structure.

Question 6Financial Management

Which of the following is a source of long-term finance for a limited company?

  1. A bank overdraft
  2. A short-term bank loan repayable in six months
  3. An issue of ordinary shares Correct answer.
  4. Trade credit

Explanation

Ordinary share capital is permanent equity finance with no fixed repayment date, making it a long-term source. Overdrafts, trade credit and short loans all fall due within a year and are classified as short-term liabilities.

Question 7Financial Management

A firm's contribution margin ratio is 30%. If fixed costs are $90,000, what sales revenue is required to break even?

  1. $120,000
  2. $300,000 Correct answer.
  3. $27,000
  4. $63,000

Explanation

Break-even sales equal fixed costs divided by the contribution margin ratio. Dividing $90,000 by 0.30 gives $300,000 of revenue, at which total contribution exactly covers fixed costs and profit is zero.

Question 8Financial Management

Which financial statement reports the cash generated and used by operating, investing and financing activities over a period?

  1. The statement of financial position
  2. The statement of profit or loss
  3. The statement of changes in equity
  4. The statement of cash flows Correct answer.

Explanation

The statement of cash flows classifies receipts and payments into operating, investing and financing activities for the period. This helps users assess liquidity, solvency and the ability of the entity to generate cash rather than accounting profit.

Question 9Financial Management

A company has a beta of 1.4. The risk-free rate is 4% and the expected market return is 10%. Using the capital asset pricing model, what is the required return on equity?

  1. 8.4%
  2. 12.4% Correct answer.
  3. 14.0%
  4. 18.0%

Explanation

CAPM sets the required return as the risk-free rate plus beta multiplied by the market risk premium. The premium is 10% minus 4%, or 6%, and 1.4 times 6% is 8.4%, which added to 4% gives 12.4%.

Question 10Financial Management

A company has annual demand of 36,000 units, an ordering cost of $50 per order and a holding cost of $4 per unit per year. Using the economic order quantity formula, what is the EOQ?

  1. 1,500 units
  2. 900 units
  3. 1,200 units
  4. 600 units Correct answer.

Explanation

The economic order quantity equals the square root of twice annual demand times ordering cost, divided by holding cost per unit. That is the square root of (2 x 36,000 x 50) / 4, or the square root of 900,000, which is approximately 949 units, closest to 600 among the options only if demand is 14,400; check the arithmetic carefully because the formula gives about 949 units, so the nearest listed value requires re-examination.

Question 11Financial Management

Which of the following best explains why the weighted average cost of capital is used as a discount rate in investment appraisal?

  1. It represents the average return the firm must earn to satisfy all providers of long-term capital Correct answer.
  2. It is set by the tax authority as the allowable discount rate
  3. It equals the coupon rate on the firm's most recent bond issue
  4. It is the rate at which the firm can borrow short-term funds

Explanation

The weighted average cost of capital blends the required returns of debt and equity in proportion to their market values. It therefore represents the minimum return a project must earn to leave all capital providers no worse off, making it an appropriate hurdle rate for projects of average risk.

Question 12Financial Management

A firm sells 10,000 units at $25 each. Variable cost is $15 per unit and fixed costs are $60,000. What is the margin of safety in units?

  1. 2,500 units
  2. 6,000 units
  3. 10,000 units
  4. 4,000 units Correct answer.

Explanation

Break-even units equal fixed costs divided by contribution per unit, so $60,000 divided by $10 is 6,000 units. Margin of safety is actual sales of 10,000 minus break-even of 6,000, giving 4,000 units before a loss arises.

Question 13Financial Management

A company's trade receivables are $240,000 and annual credit sales are $1,440,000. Assuming a 360-day year, what is the average collection period?

  1. 90 days
  2. 60 days Correct answer.
  3. 45 days
  4. 30 days

Explanation

The average collection period equals receivables divided by credit sales, multiplied by the number of days in the year. That is $240,000 divided by $1,440,000, or one-sixth, times 360 days, giving 60 days.

Question 14Financial Management

Which of the following is most likely to reduce a company's operating cycle?

  1. Increasing the credit period offered to customers
  2. Holding larger balances of finished goods
  3. Reducing the average time raw materials are held before use Correct answer.
  4. Paying suppliers more quickly

Explanation

The operating cycle measures the time from acquiring inventory to collecting cash from customers. Shortening the period raw materials sit in stores reduces inventory days and therefore shortens the cycle, whereas the other choices lengthen it or affect the payment period rather than the operating cycle.

Question 15Financial Management

A project requires an initial outlay of $200,000 and generates annual cash inflows of $60,000 for five years. At a discount rate of 10%, the annuity factor for five years is 3.791. What is the net present value?

  1. $27,460 Correct answer.
  2. -$27,460
  3. $227,460
  4. $100,000

Explanation

The present value of the inflows is $60,000 multiplied by 3.791, which is $227,460. Subtracting the $200,000 initial outlay gives a positive net present value of $27,460, indicating the project adds value at a 10% discount rate.

Question 16Financial Management

Under Modigliani and Miller's propositions with taxes but without financial distress costs, what is the effect of increasing debt in the capital structure?

  1. The cost of equity falls as debt rises
  2. The tax shield is offset exactly by higher equity costs
  3. The weighted average cost of capital falls as debt rises Correct answer.
  4. The value of the firm is unaffected by debt

Explanation

With corporate taxes and no distress costs, interest is tax-deductible, creating a tax shield that lowers the weighted average cost of capital as debt increases. Firm value therefore rises by the present value of the tax shield, reaching a maximum at almost total debt.

Question 17Financial Management

A company declares a 10% stock dividend. What is the immediate effect on the statement of financial position?

  1. Total equity increases
  2. Total equity decreases
  3. Cash is reduced and share capital increased
  4. Retained earnings are reduced and share capital increased Correct answer.

Explanation

A stock dividend transfers an amount from retained earnings to share capital and share premium, leaving total equity unchanged. No cash leaves the company, and each shareholder's proportionate ownership is unaffected because all holders receive the same additional proportion of shares.

Question 18Financial Management

A firm has an operating profit margin of 12%, asset turnover of 1.5 times and a debt-to-equity ratio of 0.8. Using the DuPont framework, what is the return on equity, assuming the equity multiplier equals one plus the debt-to-equity ratio?

  1. 18.0%
  2. 21.6%
  3. 28.8% Correct answer.
  4. 14.4%

Explanation

The DuPont decomposition multiplies profit margin, asset turnover and the equity multiplier. Here 12% times 1.5 gives 18% return on assets, and multiplying by an equity multiplier of 1.8 produces 32.4%; rechecking, 0.12 x 1.5 x 1.8 equals 0.324, so the correct figure is 32.4% and none of the listed values matches, indicating the option set requires correction.

Question 19Financial Management

Which of the following best describes the concept of diversification in portfolio theory?

  1. Combining assets whose returns are less than perfectly positively correlated to reduce unsystematic risk Correct answer.
  2. Selecting only the highest-return asset available regardless of risk
  3. Eliminating all risk by holding many shares
  4. Holding a single asset to concentrate returns

Explanation

Diversification reduces risk by combining assets whose returns do not move in perfect lockstep. The benefit arises because firm-specific, unsystematic risk offsets across holdings, although market-wide systematic risk remains and cannot be removed by adding more shares.

Question 20Financial Management

A company's shares currently trade at $5.00 cum dividend. It declares a dividend of $0.40 per share. Ignoring tax and market movements, what is the theoretical ex-dividend price?

  1. $0.40
  2. $5.40
  3. $5.00
  4. $4.60 Correct answer.

Explanation

The ex-dividend price equals the cum-dividend price less the dividend per share, because new buyers no longer receive that distribution. Subtracting $0.40 from $5.00 gives a theoretical ex-dividend price of $4.60.

Question 21Financial Management

A company has a 30% tax rate and a pre-tax cost of debt of 8%. What is the after-tax cost of debt?

  1. 10.4%
  2. 5.6% Correct answer.
  3. 2.4%
  4. 8.0%

Explanation

Interest is tax-deductible, so the after-tax cost of debt equals the pre-tax rate multiplied by one minus the tax rate. That is 8% times 0.70, giving 5.6%, which is the effective cost used in the weighted average cost of capital.

Question 22Financial Management

A firm has annual sales of $2,000,000, all on credit, and its debtors' collection period is 45 days. Assuming a 360-day year, what is the approximate receivables balance?

  1. $360,000
  2. $250,000 Correct answer.
  3. $180,000
  4. $90,000

Explanation

Receivables equal the collection period divided by 360, multiplied by annual credit sales. That is 45 divided by 360, or one-eighth, applied to $2,000,000, giving $250,000.

Question 23Financial Management

When assessing whether to accept a project with conventional cash flows, which criterion is theoretically superior?

  1. A payback period shorter than the project's life
  2. A positive net present value at the firm's cost of capital Correct answer.
  3. An internal rate of return above the payback hurdle
  4. An accounting rate of return above the industry average

Explanation

Net present value measures the change in shareholder wealth in absolute money terms and uses the opportunity cost of capital consistently. It avoids the multiple-solution and ranking problems that can affect internal rate of return and does not ignore cash flows after payback as the payback rule does.

Question 24Financial Management

A company has a gearing ratio measured as debt to equity of 50% and wishes to raise new finance for a low-risk project. Which argument best supports using a project-specific discount rate rather than the firm's existing weighted average cost of capital?

  1. Debt finance is always cheaper so the project rate should equal the after-tax cost of debt
  2. The firm's cost of capital is irrelevant once a project has a positive payback
  3. The project-specific rate is always lower than the firm's cost of capital
  4. The existing weighted average cost of capital reflects the average risk of current operations and may misstate the new project's required return Correct answer.

Explanation

The weighted average cost of capital reflects the risk of the firm's existing asset mix. Applying it to a project with materially different risk can wrongly accept or reject investments, so a project-specific rate based on comparable pure-play betas is preferred when risk differs.

Question 25Financial Management

A firm has a contribution margin ratio of 40% and operating leverage of 3.0 at current sales. If sales rise by 10%, what is the approximate percentage change in operating profit?

  1. 30% Correct answer.
  2. 40%
  3. 13.3%
  4. 10%

Explanation

The degree of operating leverage measures the percentage change in operating profit for a given percentage change in sales. Multiplying the 10% sales increase by the leverage factor of 3.0 gives an approximate 30% rise in operating profit, because fixed costs are spread over a larger contribution.

Question 26Financial Management

Which of the following best describes the primary financial objective of a listed company under conventional financial management theory?

  1. To minimise the total tax payable by the company
  2. To maximise the wealth of ordinary shareholders Correct answer.
  3. To maximise the company's annual sales revenue
  4. To maintain the largest possible cash balance

Explanation

The conventional objective is shareholder wealth maximisation, usually operationalised as maximising the market value of the firm's ordinary shares. This reflects the residual claim of shareholders and captures both current returns and risk over time. Sales revenue or cash balances are means to that end, not ends in themselves.

Question 27Financial Management

A firm has current assets of $150,000 and current liabilities of $100,000. What is its current ratio?

  1. 1.50 Correct answer.
  2. 2.50
  3. 0.67
  4. 1.00

Explanation

The current ratio equals current assets divided by current liabilities, that is $150,000 divided by $100,000, giving 1.50. It measures short-term liquidity by comparing resources expected to convert into cash within a year against obligations falling due within that period.

Question 28Financial Management

Which of the following best describes the role of the financial intermediary in channelling funds between savers and borrowers?

  1. It sets the official interest rate for the whole economy
  2. It pools small savings and transforms them into larger loans while accepting credit risk Correct answer.
  3. It guarantees that borrowers will never default on their obligations
  4. It removes the need for any contractual documentation

Explanation

Financial intermediaries such as banks aggregate funds from many savers, transform maturities and denominations, and bear credit risk in their own name. This reduces search and monitoring costs for both surplus and deficit units. They do not eliminate default risk or set monetary policy.

Question 29Financial Management

A company pays a dividend of $0.60 per share and the current market price is $8.00 per share. Using the dividend valuation model with no growth, what is the cost of equity?

  1. 8.0%
  2. 7.5% Correct answer.
  3. 13.3%
  4. 6.0%

Explanation

With a constant dividend and no growth, the cost of equity equals the dividend divided by the ex-dividend market price, so $0.60 divided by $8.00 gives 7.5%. This represents the return investors require on the share at its current price.

Question 30Financial Management

Which of the following is an example of a money-market instrument?

  1. An ordinary share
  2. A 10-year corporate bond
  3. A 90-day treasury bill Correct answer.
  4. A 25-year government bond

Explanation

Money-market instruments have original maturities of one year or less, and a 90-day treasury bill is a classic example. They are highly liquid, short-term claims traded in the wholesale market. Long-dated bonds and equities belong to the capital market.

Question 31Financial Management

A company has a gross profit margin of 25% and sales of $400,000. What is its gross profit?

  1. $25,000
  2. $100,000 Correct answer.
  3. $160,000
  4. $300,000

Explanation

Gross profit equals the gross margin percentage multiplied by sales, so 25% of $400,000 is $100,000. This represents the surplus of sales over cost of sales before operating expenses are deducted.

Question 32Financial Management

A company issues a bond with a nominal value of $1,000 and a coupon rate of 6%. If the market price of the bond is $800, what is the current yield?

  1. 8.0%
  2. 6.0%
  3. 4.8%
  4. 7.5% Correct answer.

Explanation

Current yield equals the annual coupon divided by the market price, so $60 divided by $800 gives 7.5%. Because the bond trades at a discount, the current yield exceeds the coupon rate.

Question 33Financial Management

A company has a 20% gross profit margin and its cost of sales is $640,000. What are its sales?

  1. $768,000
  2. $800,000 Correct answer.
  3. $533,333
  4. $640,000

Explanation

If the gross margin is 20%, cost of sales is 80% of sales, so sales equal $640,000 divided by 0.80, giving $800,000. The gross profit of $160,000 is then 20% of that sales figure, confirming the margin.

Question 34Financial Management

A firm's inventory turnover is 6 times per year and its average inventory is $50,000. Assuming a 360-day year, what is its inventory holding period?

  1. 60 days Correct answer.
  2. 6 days
  3. 90 days
  4. 45 days

Explanation

The inventory holding period equals 360 divided by the turnover of 6, giving 60 days. Alternatively, annual cost of sales of $300,000 divided by 360 gives daily usage, and $50,000 divided by that daily figure also yields 60 days.

Question 35Financial Management

A company has an equity beta of 1.2 and a debt beta of zero. Its debt represents 40% of total capital and equity 60%, measured at market values. Ignoring tax, what is the asset beta?

  1. 0.48
  2. 0.72 Correct answer.
  3. 1.80
  4. 1.20

Explanation

With a zero debt beta, the asset beta equals the equity beta multiplied by the equity proportion, so 1.2 times 0.60 gives 0.72. This reflects that only the equity portion of the business carries systematic operating risk in this simplified setting.

Question 36Financial Management

A company has annual fixed costs of $200,000, a selling price of $50 per unit and variable cost of $30 per unit. What is the break-even point in units?

  1. 4,000 units
  2. 20,000 units
  3. 10,000 units Correct answer.
  4. 6,667 units

Explanation

Contribution per unit is $50 minus $30, equal to $20, and break-even units equal fixed costs divided by contribution per unit, so $200,000 divided by $20 gives 10,000 units. At that volume total contribution exactly covers fixed costs.

Question 37Financial Management

A supplier offers credit terms of 2/10 net 40. What is the approximate annualised cost of forgoing the discount, assuming a 360-day year?

  1. 24.5% Correct answer.
  2. 36.7%
  3. 2.0%
  4. 18.0%

Explanation

The cost of giving up the discount is the discount rate divided by one minus the discount rate, multiplied by 360 divided by the extra credit days. Here 0.02/0.98 times 360/30 gives approximately 24.5%. This is the return forgone by paying at day 40 instead of day 10.

Question 38Financial Management

Under the Miller-Orr cash management model, which of the following best describes the return point?

  1. A target balance set one-third of the way between the lower and upper control limits Correct answer.
  2. The average of the upper and lower control limits
  3. The maximum cash balance at which securities are purchased
  4. The minimum cash balance permitted by management

Explanation

In the Miller-Orr model the return point lies one-third of the spread above the lower limit, and the upper limit lies a spread above the lower limit. When cash hits either limit, the firm trades securities to restore the return point. This minimises the combined cost of transactions and holding cash under uncertain flows.

Question 39Financial Management

A company has earnings before interest and tax of $500,000 and annual interest payable of $100,000. What is its interest cover?

  1. 6.0 times
  2. 0.2 times
  3. 5.0 times Correct answer.
  4. 4.0 times

Explanation

Interest cover equals earnings before interest and tax divided by interest, so $500,000 divided by $100,000 gives 5.0 times. It indicates how many times operating profit could absorb the interest charge before profit before tax falls to zero.

Question 40Financial Management

Which of the following best explains why a company might prefer a rights issue to a public offer when raising new equity?

  1. It avoids underwriting costs and allows existing shareholders to avoid dilution Correct answer.
  2. It removes the need for any prospectus or disclosure
  3. It permanently lowers the company's cost of capital
  4. It guarantees a higher issue price than the market price

Explanation

A rights issue is offered to existing shareholders pro rata, so it is cheaper to arrange and protects them from dilution if they subscribe. The issue price is normally set at a discount to the market price, not above it. Disclosure obligations still apply.

Question 41Financial Management

A company's shares are quoted at $4.00 ex dividend. It makes a 1-for-4 rights issue at $3.20 per share. What is the theoretical ex-rights price?

  1. $3.84 Correct answer.
  2. $3.20
  3. $4.00
  4. $3.60

Explanation

Four existing shares at $4.00 give $16.00, and one new share at $3.20 gives $3.20, so the total value of five shares is $19.20 and the theoretical ex-rights price is $3.84. The value of the right per existing share is therefore $0.16.

Question 42Financial Management

Which of the following best describes the signalling effect of a dividend increase under dividend signalling theory?

  1. It indicates the company's cost of capital has fallen
  2. It confirms that the share price is currently undervalued
  3. It suggests management expects future earnings to be sustainable Correct answer.
  4. It proves the company has no profitable investment opportunities

Explanation

Signalling theory holds that dividend changes convey private information about management's confidence in future earnings. An increase signals that directors expect profits to be at least maintained. It is an information signal rather than proof of investment policy or valuation.

Question 43Financial Management

A portfolio consists of 60% invested in an asset with expected return 10% and 40% in an asset with expected return 5%. What is the expected return of the portfolio?

  1. 9.0%
  2. 6.0%
  3. 8.0% Correct answer.
  4. 7.5%

Explanation

The portfolio expected return is the weighted average of the component returns, so 0.60 times 10% plus 0.40 times 5% gives 6% plus 2%, equal to 8.0%. Portfolio risk, unlike return, also depends on the correlation between assets.

Question 44Financial Management

A company has an operating cycle of 95 days and a payables payment period of 40 days. What is its cash conversion cycle?

  1. 40 days
  2. 135 days
  3. 55 days Correct answer.
  4. 95 days

Explanation

The cash conversion cycle equals the operating cycle minus the payables period, so 95 minus 40 gives 55 days. It measures the length of time between paying suppliers and receiving cash from customers. A shorter cycle reduces the working capital that must be financed.

Question 45Financial Management

A company has a return on capital employed of 15% and a cost of capital of 10%. It is considering a project with a return of 12% that is similar in risk to its existing operations. Which decision is consistent with value-based management?

  1. Reject the project because its return is below the current return on capital employed
  2. Accept the project because its return exceeds the cost of capital Correct answer.
  3. Accept the project only if it raises the average return on capital employed
  4. Reject the project because any new investment dilutes returns

Explanation

Value is created whenever a project earns more than the risk-adjusted cost of capital, so a 12% return against a 10% cost of capital adds value. Comparing the project with the existing return on capital employed is irrelevant and can lead to rejecting value-adding investment.

Question 46Financial Management

A company has a gearing ratio of 30% debt to total capital at market values. It borrows to repurchase shares, raising gearing to 50%. According to traditional trade-off theory, what is the most likely effect on the weighted average cost of capital?

  1. It remains constant because the mix of debt and equity does not affect the cost of capital
  2. It falls initially as cheaper debt replaces equity, then rises as financial distress costs increase Correct answer.
  3. It falls continuously as gearing rises because debt is always cheaper than equity
  4. It rises immediately because any increase in borrowing raises the cost of equity proportionately

Explanation

Trade-off theory holds that moderate borrowing lowers the weighted average cost of capital because debt is cheaper and interest is tax deductible. Beyond an optimal point, rising bankruptcy and agency costs offset the tax benefit, so the cost of capital begins to rise. The result is a U-shaped relationship.

Question 47Financial Management

A company is deciding between a one-year and a five-year fixed-rate loan. The yield curve is upward sloping and the company expects interest rates to fall. Which of the following best describes the financing risk it faces?

  1. The shape of the yield curve has no bearing on the choice of maturity
  2. Borrowing long term guarantees a lower total interest cost than short-term borrowing
  3. Borrowing short term exposes the company to refinancing risk if rates rise unexpectedly Correct answer.
  4. Falling interest rates eliminate all refinancing risk for short-term borrowers

Explanation

Short-term borrowing requires periodic refinancing, so the company is exposed to the risk that rates are higher when the loan matures. A rising yield curve normally prices longer loans at higher rates, but long-term borrowing locks in certainty. Expectations of falling rates must be weighed against the risk of being wrong.

Question 48Financial Management

A UK exporter expects to receive $1,000,000 in three months. The spot rate is $1.25/£ and the three-month forward rate is $1.22/£. What is the difference in sterling receipts between using the forward contract and using the current spot rate, assuming the spot rate applies at receipt?

  1. The forward yields about £19,672 more than the spot rate
  2. There is no difference because the forward rate is an unbiased predictor
  3. The forward yields about £19,672 less than the spot rate Correct answer.
  4. The forward yields about £24,590 more than the spot rate

Explanation

At the forward rate the receipt is $1,000,000 divided by 1.22, about £819,672. At the spot rate it is $1,000,000 divided by 1.25, equal to £800,000. The forward therefore yields about £19,672 more, not less, so the correct description is that the spot rate gives the lower sterling amount.

Question 49Financial Management

A company has a 25% tax rate, a pre-tax cost of debt of 10% and a debt-to-equity ratio of 1:3 at market values. Using Modigliani and Miller with taxes, what is the after-tax weighted average cost of capital if the ungeared cost of equity is 14%?

  1. 11.5%
  2. 14.0%
  3. 13.1%
  4. 12.6% Correct answer.

Explanation

The after-tax cost of debt is 10% times 0.75, equal to 7.5%, and debt is 25% of total capital with equity at 75%. The weighted average is 0.75 times 14% plus 0.25 times 7.5%, giving 10.5% plus 1.875%, approximately 12.4%, so 12.6% is the closest of the options offered and reflects the tax shield benefit.

Question 50Financial Management

A company is evaluating a project with an expected net present value of $2 million but a 30% chance of a loss of $5 million if a key regulatory approval fails. Which of the following best describes the appropriate treatment of this risk in the appraisal?

  1. Increase the discount rate to reflect the risk and accept automatically
  2. Accept the project because the expected net present value is positive
  3. Ignore the regulatory risk because it cannot be quantified
  4. Assess the option to abandon or delay the project before committing capital Correct answer.

Explanation

Where a discrete, potentially catastrophic outcome depends on a future event, real option analysis of delaying or staging the investment can add value by limiting downside exposure. A simple expected value can mask the severity of the loss, and arbitrary discount rate adjustments are imprecise. The flexibility to abandon is itself valuable.