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CIMA CGMA - independent subject foundations practice questions

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Question 1Financial statements, assets, inventory and cash-flow models

Under IAS 1 'Presentation of Financial Statements', a complete set of financial statements MUST include all of the following EXCEPT:

  1. A statement of financial position
  2. A statement of profit or loss and other comprehensive income
  3. A statement of cash flows
  4. A statement of board-approved budget for the next year Correct answer.

Explanation

IAS 1 requires: (1) a statement of financial position, (2) a statement of profit or loss and OCI, (3) a statement of changes in equity, (4) a statement of cash flows (per IAS 7), and (5) notes. A budget statement is internal management information - not part of IFRS financial statements.

Question 2Financial statements, assets, inventory and cash-flow models

Under IAS 16 'Property, Plant and Equipment', the COST of a self-constructed asset includes all of the following EXCEPT:

  1. Directly attributable costs of bringing the asset to working condition
  2. Initial estimate of decommissioning costs
  3. Borrowing costs (where IAS 23 applies)
  4. Internal profits/markups added by the construction division Correct answer.

Explanation

Internal profits or notional intra-group markups are eliminated when capitalising self-constructed assets. IAS 16 cost includes purchase price, directly attributable costs, decommissioning provisions (per IAS 37), and capitalised borrowing costs under IAS 23 for qualifying assets.

Question 3Financial statements, assets, inventory and cash-flow models

Under IFRS 15 'Revenue from Contracts with Customers', revenue is recognised when:

  1. Cash is received from the customer
  2. Control of the goods or services transfers to the customer Correct answer.
  3. The contract is signed
  4. The invoice is issued

Explanation

IFRS 15's core principle: revenue is recognised when (or as) the entity satisfies a performance obligation by transferring control of a promised good or service to the customer. The 5-step model: identify contract → identify POs → determine transaction price → allocate price to POs → recognise revenue when PO is satisfied.

Question 4Financial statements, assets, inventory and cash-flow models

Under IFRS 16 'Leases', a lessee must generally recognise:

  1. Only an expense in profit or loss for all leases
  2. A right-of-use asset and a lease liability for most leases Correct answer.
  3. Lease payments only as cash flows from financing
  4. Only operating leases on the balance sheet

Explanation

IFRS 16 (effective 2019) requires lessees to recognise a right-of-use (ROU) asset and a corresponding lease liability for substantially all leases. Exemptions exist for short-term leases (<12 months) and low-value assets. This eliminates the previous IAS 17 operating-lease off-balance-sheet treatment.

Question 5Financial statements, assets, inventory and cash-flow models

Under IAS 36 'Impairment of Assets', the recoverable amount of an asset is the:

  1. Original cost less accumulated depreciation
  2. Higher of fair value less costs of disposal and value in use Correct answer.
  3. Lower of fair value less costs of disposal and value in use
  4. Tax-base value

Explanation

IAS 36 defines recoverable amount as the HIGHER of (a) fair value less costs of disposal, and (b) value in use (the present value of future cash flows from the asset). An impairment loss arises when carrying amount exceeds recoverable amount.

Question 6Financial statements, assets, inventory and cash-flow models

Under IAS 37 'Provisions, Contingent Liabilities and Contingent Assets', a PROVISION is recognised when:

  1. A possible obligation may or may not exist
  2. There is a present obligation, probable outflow, and reliable estimate Correct answer.
  3. Management decides to set aside funds
  4. An asset is acquired

Explanation

IAS 37 requires three conditions to recognise a provision: (1) a present obligation (legal or constructive) from a past event, (2) probable (more likely than not) outflow of economic benefits, and (3) reliable estimate of the amount. Otherwise, a contingent liability is disclosed (or, if remote, ignored).

Question 7Financial statements, assets, inventory and cash-flow models

Under IFRS 9 'Financial Instruments', loans and most trade receivables are subject to which impairment model?

  1. Incurred loss model
  2. Expected credit loss (ECL) model Correct answer.
  3. Lower-of-cost-or-market model
  4. FIFO impairment model

Explanation

IFRS 9 replaced the IAS 39 'incurred loss' model with a forward-looking 'expected credit loss' (ECL) model. Entities must recognise lifetime ECL on origination for trade receivables and a 12-month ECL (or lifetime if credit risk has significantly increased) on financial assets at amortised cost.

Question 8Financial statements, assets, inventory and cash-flow models

Under F1 principles of taxation, which of the following BEST describes the difference between tax avoidance and tax evasion?

  1. Avoidance is legal, evasion is illegal Correct answer.
  2. Avoidance is illegal, evasion is legal
  3. Both are illegal
  4. Both are legal

Explanation

Tax avoidance uses legal means (allowances, structures, deductions) to reduce tax liability. Tax evasion is the illegal non-payment or under-payment of tax (e.g., concealing income, false invoices). CIMA's ethics framework also flags 'aggressive avoidance' as ethically questionable even if legal.

Question 9Financial statements, assets, inventory and cash-flow models

An asset has a carrying amount of £1,000,000 and a tax base of £700,000. The tax rate is 25%. What deferred tax balance arises under IAS 12?

  1. £75,000 deferred tax asset
  2. £75,000 deferred tax liability Correct answer.
  3. £300,000 deferred tax liability
  4. Nil

Explanation

Taxable temporary difference = Carrying amount £1,000,000 − Tax base £700,000 = £300,000. Deferred tax liability = £300,000 × 25% = £75,000. (When carrying > tax base for an asset, a DTL arises because the larger future taxable economic benefits will be taxed.)

Question 10Financial statements, assets, inventory and cash-flow models

Under IFRS, the statement of cash flows (IAS 7) classifies cash outflows for the purchase of property, plant and equipment as:

  1. Operating activities
  2. Investing activities Correct answer.
  3. Financing activities
  4. Other comprehensive income

Explanation

IAS 7 classifies cash flows into three categories: operating (principal revenue-producing activities), investing (acquisition/disposal of long-term assets), and financing (changes in equity and borrowings). Buying PP&E is investing.

Question 11Group reporting, control and consolidation foundations

Under IFRS 10 'Consolidated Financial Statements', a parent must consolidate an entity if it has CONTROL, defined as having:

  1. Just over 50% of voting rights only
  2. Power, exposure to variable returns, AND the ability to use power to affect returns Correct answer.
  3. Any equity stake
  4. A board representative

Explanation

IFRS 10 defines control by three elements (all required): (1) power over the investee, (2) exposure or rights to variable returns, and (3) the ability to use that power to affect those returns. This 'principle-based' definition can result in control even with less than 50% (de facto control) or no control with more (e.g., protective rights only).

Question 12Group reporting, control and consolidation foundations

Under IFRS 3 'Business Combinations', goodwill arising on acquisition is calculated as:

  1. Consideration paid only
  2. Consideration + Non-controlling interest + previously held interest − Fair value of identifiable net assets acquired Correct answer.
  3. Net assets acquired only
  4. Consideration − Book value of net assets

Explanation

Full IFRS 3 goodwill: Goodwill = (Consideration transferred + NCI at fair value or proportionate share of net assets + Fair value of any previously held interest) − Fair value of identifiable net assets acquired. Goodwill is then tested annually for impairment under IAS 36 (no amortisation).

Question 13Group reporting, control and consolidation foundations

P acquires 80% of S for £400. Fair value of S's identifiable net assets at acquisition = £450. NCI is measured at proportionate share of net assets. Goodwill on acquisition = ?

  1. £40 Correct answer.
  2. £50
  3. £90
  4. Negative goodwill (gain on bargain purchase)

Explanation

Proportionate-share method: NCI = 20% × £450 = £90. Goodwill = (£400 + £90) − £450 = £40. Under the full goodwill (fair value) method, NCI fair value (often given) would replace the £90 figure.

Question 14Group reporting, control and consolidation foundations

Under IAS 28 'Investments in Associates and Joint Ventures', an associate is normally one in which the investor holds:

  1. More than 50% of voting rights
  2. Significant influence - typically 20% to 50% of voting rights Correct answer.
  3. Less than 5%
  4. 100% of equity

Explanation

An associate is an entity over which the investor has significant influence - the power to participate in financial and operating decisions but not control. The 20-50% holding range gives a presumption of significant influence. Associates are accounted for using the equity method.

Question 15Group reporting, control and consolidation foundations

Under the equity method (IAS 28) for associates, the investment is initially recognised at COST and subsequently:

  1. Marked to market through OCI
  2. Adjusted for the investor's share of the associate's post-acquisition profit/loss and OCI, less dividends received Correct answer.
  3. Held at cost less impairment only
  4. Consolidated line by line

Explanation

Equity method: investment = Cost + share of post-acquisition profits − share of post-acquisition losses − dividends received − impairment. Share of profit appears in P&L, share of OCI in OCI. Associates are NOT line-by-line consolidated (that's for subsidiaries under IFRS 10).

Question 16Group reporting, control and consolidation foundations

Intra-group sales between parent and subsidiary in a consolidated income statement must be:

  1. Doubled to show both sides
  2. Eliminated in full to avoid double counting Correct answer.
  3. Disclosed as related-party transactions only without elimination
  4. Reported as exceptional items

Explanation

Consolidation eliminates intra-group transactions in full to present the group as a single economic entity. Intra-group sales are removed from revenue and cost of sales. Unrealised profit on inventory still held at year-end is also eliminated (provision for unrealised profit, PURP).

Question 17Group reporting, control and consolidation foundations

Under IAS 21 'The Effects of Changes in Foreign Exchange Rates', a foreign subsidiary's statement of financial position items are translated at:

  1. Historical exchange rate
  2. Average rate for the period
  3. Closing (spot) rate at the reporting date Correct answer.
  4. Rate set by the parent's central bank

Explanation

IAS 21 closing-rate (current-rate) method for foreign subsidiaries: SFP items at closing rate; income statement items at the rate at the date of the transaction (or an average rate if rates do not fluctuate significantly); resulting exchange differences in OCI (translation reserve).

Question 18Group reporting, control and consolidation foundations

Return on Capital Employed (ROCE) is calculated as:

  1. Operating profit ÷ (Equity + Long-term debt) Correct answer.
  2. Net profit ÷ Total revenue
  3. Gross profit ÷ Total assets
  4. Operating cash flow ÷ Net assets

Explanation

ROCE = Operating profit (PBIT) ÷ Capital employed, where capital employed = total equity + long-term debt (or total assets − current liabilities). Used widely for analysis in F2/F3 and for measuring divisional performance in P2.

Question 19Group reporting, control and consolidation foundations

Earnings Per Share (EPS) under IAS 33 (basic) is calculated as:

  1. Profit attributable to ordinary shareholders ÷ Weighted average number of ordinary shares outstanding Correct answer.
  2. Net profit ÷ Total assets
  3. Dividend ÷ Share price
  4. Profit ÷ Number of shares issued at year-end

Explanation

Basic EPS = Profit/loss attributable to ordinary equity holders ÷ Weighted average number of ordinary shares outstanding. The weighted average reflects shares issued/repurchased during the period. Diluted EPS adjusts for potential ordinary shares (convertibles, options, warrants).

Question 20Group reporting, control and consolidation foundations

Under IFRS 5 'Non-current Assets Held for Sale and Discontinued Operations', a non-current asset classified as held for sale is measured at:

  1. Higher of carrying amount and fair value less costs to sell
  2. Lower of carrying amount and fair value less costs to sell Correct answer.
  3. Always at fair value
  4. Always at historical cost

Explanation

IFRS 5: a non-current asset (or disposal group) classified as held for sale is measured at the LOWER of carrying amount and fair value less costs to sell. Depreciation ceases. The asset is presented separately on the SFP. Discontinued operations are presented as a single line on the income statement.

Question 21Group reporting, control and consolidation foundations

Under IFRS 8 'Operating Segments', segment information must be disclosed based on:

  1. Geographical regions only
  2. Industry sectors only
  3. The components reviewed by the chief operating decision maker (CODM) - the 'management approach' Correct answer.
  4. All entities equally

Explanation

IFRS 8 adopts the 'management approach': segments reported externally must mirror the components for which discrete financial information is regularly reviewed by the CODM (e.g., the CEO or executive team) for resource allocation. This may be by product, geography, customer, or otherwise.

Question 22Group reporting, control and consolidation foundations

P acquires 100% of S on 1 Jan. S sold inventory to P during the year for £50, originally costing S £30. At year-end, P still holds 60% of these goods. The intra-group profit elimination (PURP) reduces consolidated inventory and group retained earnings by:

  1. £12 Correct answer.
  2. £20
  3. £30
  4. £50

Explanation

Intra-group margin = £50 − £30 = £20. Unsold portion = 60%. Unrealised profit (PURP) = £20 × 60% = £12. The £12 is removed from inventory and from group retained earnings (the seller's profit). Standard F2 consolidation adjustment.

Question 23Management costing, budgets and relevant decisions

Under absorption costing, which of the following is INCLUDED in the cost of inventory?

  1. Variable production overheads only
  2. Fixed production overheads only
  3. Both variable and fixed production overheads Correct answer.
  4. Selling and administrative costs

Explanation

Absorption costing assigns BOTH variable and fixed production overheads to inventory (full production cost). Marginal costing assigns only variable production costs. Selling and administrative costs are period costs under both methods. This is a core P1 distinction.

Question 24Management costing, budgets and relevant decisions

A company budgets to use 5,000 kg of material at £4/kg. Actual usage was 5,400 kg at £3.80/kg. What is the material PRICE variance?

  1. £1,080 favourable Correct answer.
  2. £1,080 adverse
  3. £1,000 favourable
  4. £1,600 adverse

Explanation

Material price variance = (Standard price − Actual price) × Actual quantity = (£4.00 − £3.80) × 5,400 = £0.20 × 5,400 = £1,080 favourable (the company paid less per kg than standard).

Question 25Management costing, budgets and relevant decisions

Using the same data as the prior question (budget 5,000 kg @ £4; actual 5,400 kg @ £3.80, with budgeted output achieved), the material USAGE variance is:

  1. £1,600 favourable
  2. £1,600 adverse Correct answer.
  3. £1,520 adverse
  4. £400 adverse

Explanation

Material usage variance = (Standard quantity − Actual quantity) × Standard price = (5,000 − 5,400) × £4 = −400 × £4 = £1,600 adverse (used more material than expected for the output achieved).

Question 26Management costing, budgets and relevant decisions

A company applies Activity-Based Costing (ABC). Which of the following is the correct sequence of steps?

  1. Identify cost pools → identify cost drivers → calculate driver rates → assign costs to products Correct answer.
  2. Assign costs to products → identify cost pools → calculate driver rates → identify cost drivers
  3. Calculate driver rates → assign to products → identify pools → identify drivers
  4. Identify products → assign profit margins → identify pools → calculate variances

Explanation

The standard ABC sequence is: (1) identify activities and group costs into pools, (2) identify a cost driver for each pool, (3) calculate a cost-driver rate (pool cost ÷ total driver activity), and (4) assign costs to products based on driver consumption. This is examined frequently in P1 and P2.

Question 27Management costing, budgets and relevant decisions

Process costing is MOST appropriate for which of the following industries?

  1. Bespoke yacht building
  2. Custom legal advisory work
  3. Oil refining Correct answer.
  4. One-off building construction

Explanation

Process costing is used where homogeneous units pass through continuous processes (oil refining, chemicals, food processing). Costs are averaged across units. Job costing is used for unique, identifiable jobs (yachts, legal work, construction).

Question 28Management costing, budgets and relevant decisions

A product sells for £50 and has variable cost of £30 per unit. Fixed costs are £200,000. What is the breakeven point in units?

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

Explanation

Breakeven units = Fixed costs ÷ Contribution per unit. Contribution = £50 − £30 = £20. Breakeven = £200,000 ÷ £20 = 10,000 units.

Question 29Management costing, budgets and relevant decisions

Which costing method is consistent with IAS 2 'Inventories' for external financial reporting?

  1. Marginal costing
  2. Throughput costing
  3. Absorption costing Correct answer.
  4. Direct costing

Explanation

IAS 2 requires inventory to be measured at the lower of cost and net realisable value, with cost including all production costs (direct materials, direct labour, and a systematic allocation of fixed and variable production overheads). This is absorption costing. Marginal/throughput/direct costing exclude fixed overhead and are not IFRS-compliant.

Question 30Management costing, budgets and relevant decisions

A flexed budget is BEST described as:

  1. A budget that never changes after approval
  2. A budget restated for the actual level of activity, used to compare with actual results Correct answer.
  3. A budget that uses zero-based budgeting principles
  4. A budget calculated quarterly

Explanation

A flexed (or flexible) budget restates the original budget to reflect the actual activity level, isolating volume effects so that price and efficiency variances can be analysed cleanly. This is a key P1 technique.

Question 31Management costing, budgets and relevant decisions

Standard hours produced were 4,000. Actual hours worked were 4,200 at a standard rate of £10/hour but actual rate of £11/hour. What is the labour EFFICIENCY (usage) variance?

  1. £2,000 adverse Correct answer.
  2. £2,000 favourable
  3. £2,200 adverse
  4. £4,200 adverse

Explanation

Labour efficiency variance = (Standard hours − Actual hours) × Standard rate = (4,000 − 4,200) × £10 = −200 × £10 = £2,000 adverse (more hours worked than standard).

Question 32Management costing, budgets and relevant decisions

A company has limited machine hours and must choose which of three products to make. The optimum decision rule is to:

  1. Maximise the contribution per unit
  2. Maximise the contribution per machine hour (limiting factor) Correct answer.
  3. Maximise revenue per unit
  4. Minimise variable cost per unit

Explanation

When a single resource is the binding constraint, products should be ranked by contribution per unit of the limiting factor (here, contribution per machine hour). This maximises total contribution given the constraint. This is a classic P1 short-term decision.

Question 33Management costing, budgets and relevant decisions

A make-or-buy decision requires comparing:

  1. Total cost of making vs total cost of buying, including all sunk costs
  2. Relevant (avoidable) cost of making vs purchase cost from supplier Correct answer.
  3. Historical depreciation only
  4. Only the supplier's price

Explanation

Only relevant (future, incremental, avoidable, cash) costs matter for short-term decisions. Sunk costs (e.g., past R&D) are ignored. Compare avoidable cost of making with the purchase cost. This is a fundamental relevant-costing principle in P1/P2.

Question 34Management costing, budgets and relevant decisions

Under throughput accounting (Theory of Constraints), 'throughput' is defined as:

  1. Sales revenue minus all costs
  2. Sales revenue minus only direct material cost Correct answer.
  3. Sales revenue minus all variable costs
  4. Total production volume

Explanation

In TOC/throughput accounting, throughput = sales revenue − totally variable cost (typically only direct material). Labour and most overheads are treated as fixed 'operating expenses' in the short term. The throughput accounting ratio (TAR) = throughput per bottleneck hour ÷ operating expense per bottleneck hour.

Question 35Management costing, budgets and relevant decisions

A company has spare capacity. Variable cost per unit is £30, fixed cost per unit (full absorption) is £15, and normal selling price is £60. A one-off export order is offered at £40/unit. Should the company accept it (assume no displacement of normal sales)?

  1. Reject - price is below full cost of £45
  2. Accept - price exceeds variable (relevant) cost of £30 Correct answer.
  3. Reject - price is below normal selling price
  4. Indifferent - the price equals fixed cost plus variable cost

Explanation

For a special order with spare capacity and no displacement, only relevant (variable) costs apply. Contribution per unit = £40 − £30 = £10 positive, so the order increases profit. Fixed costs are sunk in the short term and irrelevant.

Question 36Management costing, budgets and relevant decisions

A company uses a 'cost-plus' pricing approach with a 25% mark-up on variable cost. Variable cost is £80/unit. What is the selling price?

  1. £100 Correct answer.
  2. £105
  3. £106.67
  4. £120

Explanation

Mark-up on variable cost: Selling price = £80 × (1 + 25%) = £80 × 1.25 = £100. Note: mark-up percentages refer to cost; margin percentages refer to selling price - a common P2 distractor.

Question 37Management costing, budgets and relevant decisions

Target costing begins with:

  1. Calculating actual cost from production
  2. Identifying a market-determined target selling price and required profit margin to derive a target cost Correct answer.
  3. Adding desired profit to historical cost
  4. Setting a budget for next year

Explanation

Target costing (Japanese origin, used widely in P2) starts with the price the market will accept, deducts the required margin, and derives a target cost: Target cost = Target price − Target profit. Engineers and finance then work to design the product within that cost. The reverse of cost-plus.

Question 38Management costing, budgets and relevant decisions

Residual Income (RI) is calculated as:

  1. Profit ÷ Capital employed
  2. Profit − (Capital employed × Cost of capital) Correct answer.
  3. Sales − Variable cost
  4. Net profit + Depreciation

Explanation

Residual Income = Profit − (Capital employed × Required return). It measures absolute economic profit above the capital charge, addressing the dysfunctional rejection problem of ROI. EVA® is a refined version of RI with accounting adjustments (e.g., R&D capitalisation).

Question 39Management costing, budgets and relevant decisions

Zero-Based Budgeting (ZBB) requires:

  1. Building each budget from a zero base, justifying every line of expenditure each cycle Correct answer.
  2. Setting all budgets to zero growth
  3. Using last year's budget plus inflation
  4. Eliminating all variable costs

Explanation

ZBB starts each budget cycle from zero and requires managers to justify all expenditure as if the activity were new. It contrasts with incremental budgeting (last year + adjustment). ZBB is rigorous but time-consuming; P2 covers it alongside activity-based budgeting (ABB) and rolling budgets.

Question 40Management costing, budgets and relevant decisions

A learning curve has an 80% rate. The first unit took 100 hours. According to the cumulative average-time learning model, what is the cumulative average time per unit after 2 units?

  1. 80 hours Correct answer.
  2. 100 hours
  3. 120 hours
  4. 160 hours

Explanation

Wright's cumulative average-time learning model: each doubling of cumulative output reduces the cumulative average time per unit by the learning rate. With an 80% rate, 2 units → 100 × 0.80 = 80 hours/unit average. Total time for 2 units = 160 hours; second unit alone = 60 hours.

Question 41Management costing, budgets and relevant decisions

Under linear programming for product-mix decisions, the optimal solution is found at:

  1. The origin of the graph
  2. A vertex (corner point) of the feasible region Correct answer.
  3. The midpoint of the feasible region
  4. The point of highest cost

Explanation

Linear programming theorem: with linear constraints and a linear objective function, the optimum lies at a vertex (corner) of the feasible region. P2 uses the graphical method (2 products) and the simplex/iso-contribution line technique.

Question 42Management costing, budgets and relevant decisions

Beyond Budgeting (Hope and Fraser) advocates:

  1. More detailed annual budgets with monthly variance reports
  2. Replacing fixed annual budgets with relative targets, rolling forecasts, and decentralised decision-making Correct answer.
  3. Adopting only zero-based budgeting
  4. Requiring all departments to submit weekly budgets

Explanation

Beyond Budgeting (BBRT - Hope and Fraser) argues that traditional fixed annual budgets are dysfunctional and slow. It proposes relative performance targets (vs peers/league tables), rolling forecasts, and devolving authority. Adopted by Statoil, Handelsbanken, and others. Examined in P2 advanced budgeting.

Question 43Financial appraisal, financing and conditional valuation models

A project requires an initial investment of £100,000 and is expected to generate cash inflows of £40,000 per year for 4 years. The cost of capital is 10%. Using the annuity factor of 3.170 for 4 years at 10%, what is the NPV?

  1. £26,800 Correct answer.
  2. £60,000
  3. £100,000
  4. £126,800

Explanation

PV of inflows = £40,000 × 3.170 = £126,800. NPV = PV inflows − initial investment = £126,800 − £100,000 = £26,800. Since NPV is positive, accept the project. NPV is the gold-standard P2/F3 capital appraisal technique.

Question 44Financial appraisal, financing and conditional valuation models

The Internal Rate of Return (IRR) of a project is BEST described as:

  1. The discount rate that gives a positive NPV
  2. The discount rate at which NPV equals zero Correct answer.
  3. The highest possible return
  4. The risk-free rate

Explanation

IRR is the discount rate that makes NPV = 0. A project is acceptable if IRR exceeds the cost of capital. IRR can mislead in non-conventional cash flow patterns (multiple sign changes give multiple IRRs), so NPV is the preferred technique. P2 covers both.

Question 45Financial appraisal, financing and conditional valuation models

A division earns return on investment (ROI) of 18%. The group's cost of capital is 12%. The divisional manager is offered a new project earning 15% ROI. Under ROI-based performance evaluation, the manager will likely:

  1. Accept the project because 15% exceeds 12%
  2. Reject the project because 15% is below the divisional ROI of 18% (dysfunctional behaviour) Correct answer.
  3. Be indifferent
  4. Need shareholder approval

Explanation

Classic ROI dysfunction: the manager rejects a value-adding project (15% > 12% cost of capital) because it dilutes their average ROI. Residual income (RI) and EVA avoid this problem by measuring incremental value above the capital charge. P2 highlights this as a key control weakness of ROI.

Question 46Financial appraisal, financing and conditional valuation models

Sensitivity analysis in capital investment appraisal:

  1. Removes all uncertainty
  2. Tests how much each input variable can change before the NPV becomes zero Correct answer.
  3. Calculates exact probabilities of success
  4. Replaces the need for NPV

Explanation

Sensitivity analysis identifies the percentage change in each input (sales price, volume, cost, life) that would reduce NPV to zero. Inputs with the smallest tolerance are highest-risk. CIMA P2/F3 also covers scenario analysis, simulation, and decision trees for risk.

Question 47Financial appraisal, financing and conditional valuation models

Under the Capital Asset Pricing Model (CAPM), the required return on equity (Re) is:

  1. Re = Rf × β
  2. Re = Rf + β × (Rm − Rf) Correct answer.
  3. Re = Rm − Rf
  4. Re = β + Rm

Explanation

CAPM: Re = Rf + β × (Rm − Rf), where Rf is the risk-free rate, Rm is the expected market return, and β is the equity beta capturing systematic risk. The market risk premium is (Rm − Rf). Core F3 financial-strategy formula for cost of equity.

Question 48Financial appraisal, financing and conditional valuation models

A company has Re = 12%, Rd = 6%, debt-to-value (D/V) = 40%, equity-to-value (E/V) = 60%, and tax rate T = 25%. Calculate the WACC.

  1. 7.20%
  2. 9.00% Correct answer.
  3. 9.60%
  4. 12.00%

Explanation

WACC = E/V × Re + D/V × Rd × (1 − T) = 0.60 × 12% + 0.40 × 6% × 0.75 = 7.20% + 1.80% = 9.00%. The (1 − T) reflects the tax-deductibility of interest. Used as the discount rate for new projects of average risk.

Question 49Financial appraisal, financing and conditional valuation models

Modigliani-Miller's Proposition I (no taxes, perfect markets) states that:

  1. A firm's value depends solely on its dividend policy
  2. A firm's value is independent of its capital structure Correct answer.
  3. Higher debt always reduces firm value
  4. Equity is always cheaper than debt

Explanation

M&M Proposition I (1958, no taxes): in a frictionless market, a firm's total value is determined by its operating cash flows and risk, not by its capital structure mix. With taxes (M&M with tax), debt creates a tax shield and can increase value - but offset by financial distress costs (trade-off theory).

Question 50Financial appraisal, financing and conditional valuation models

Using the Gordon Growth Model (Dividend Discount Model), a share with next-year dividend D1 = £2, expected growth g = 4%, and required return r = 10%, has a fair value per share of:

  1. £14.29
  2. £20.00
  3. £33.33 Correct answer.
  4. £50.00

Explanation

Gordon Growth Model: P0 = D1 ÷ (r − g) = £2 ÷ (0.10 − 0.04) = £2 ÷ 0.06 = £33.33. Used in F3 for equity valuation (and as a step within DCF terminal value). Requires r > g and stable, perpetual growth assumption.